Loading the player...

What is a 'Synthetic CDO'

A synthetic CDO is a form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other noncash assets to gain exposure to a portfolio of fixed income assets. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.

BREAKING DOWN 'Synthetic CDO'

In a synthetic CDO, all tranches will receive periodic payments based on the cash flows from the credit default swaps. Normally, the payoffs of synthetic CDOs are only affected by credit events associated with CDSs. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its investors become responsible for the losses, starting from the lowest rated tranches and working its way up. Synthetic CDOs are a modern advance in structured finance that can offer extremely high yields to investors. However, investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio.

Tranches

Tranches are also known as slices of credit risk between risk levels. Normally, the tranches primarily used in CDOs are typically known as senior, mezzanine and equity. The senior tranche includes securities with high credit ratings and tends to be low risk and therefore have lower returns. Conversely, an equity-level tranche carries a higher degree of risk and holds derivatives with lower credit ratings, so it offers higher returns. Although the equity-level tranche may offer higher returns, it is the first tranche that would absorb any potential losses.

Tranches make synthetic CDOs attractive to investors because they are able to gain exposure to CDSs based on their risk appetite. For example, assume an investor wishes to invest in a high-rated synthetic CDO that included U.S. Treasury bonds and corporate bonds that are rated AAA, the highest credit rating offered by Standard & Poor's. Therefore, the bank creates the synthetic CDO that offers to pay the U.S. Treasury bond's yield plus the corporate bonds' yields. This would be a single tranche synthetic CDO that only include the senior-level tranche.

History of Synthetic CDOs

Synthetic CDOs were first created in the late 1990s as a way for large holders of commercial loans to protect their balance sheets without actually selling the loans and potentially harming client relationships. They have become increasingly popular because they tend to have shorter life spans than cash flow CDOs, and there is no extended ramp-up period for earnings investment. Synthetic CDOs are also highly customizable between the underwriter and investors.

RELATED TERMS
  1. Collateralized Debt Obligation ...

    A special purpose vehicle (SPV) with securitization payments ...
  2. Synthetic Call

    An investment strategy that mimics the payoff of a call option. ...
  3. Synthetic

    A financial instrument that is created artificially by simulating ...
  4. Synthetic Forward Contract

    A position in which the investor is long a call option and short ...
  5. Synthetic Biology

    Synthetic biology is the engineering of biomatter DNA to form ...
  6. Credit Tranche

    A system used by the International Monetary Fund (IMF) to govern ...
Related Articles
  1. Investing

    The Return of CDOs After the 2008 Financial Crisis

    Learn how the market for CDOs is coming back after the 2008 financial crisis, and understand how the market for these products has changed.
  2. Financial Advisor

    Collateralized Debt Obligations: From Boon To Burden

    CDOs were to be Wall Street's boon - instead they went bust. Find out what went wrong.
  3. Personal Finance

    Why Are Mortgage Rates Increasing?

    Learn how the secondary mortgage market and investor demand affect the cost of home ownership.
  4. Investing

    What are Tranches?

    Tranches often describe specific classes of bonds within a security that hold different degrees of risks and maturities.
  5. Investing

    3 Bonds You May Have Never Heard Of

    These lesser-known bonds may give your portfolio a boost when other investments products fall short.
  6. Investing

    A Primer On Collateralized Debt Obligation (CDOs)

    A collateralized debt obligation, or CDO, is a structured financial product backed by a pool of loans. When a retail or commercial bank approves loans such as mortgages, auto loans or credit ...
  7. Trading

    Synthetic Options Provide Real Advantages

    Participate in options trading trading that is simpler, less expensive and easier to manage.
  8. Trading

    Get Into Low-Cost Futures Trading With Synthetics

    If you can't trade commodity futures outright, these vehicles provide a less expensive alternative.
  9. Tech

    Investopedia's Top Trending Terms of 2016

    A look at the biggest anxieties and concerns of an event-filled year through surges in traffic to these financial terms.
  10. Trading

    Put-Call Parity And Arbitrage Opportunity

    Look at trades that are profitable when the value of corresponding puts and calls diverge.
RELATED FAQS
  1. What is a tranche?

    "Tranche" is actually a French word meaning "slice" or "portion". In the world of investing, it is used to describe a security ... Read Answer >>
  2. What's the difference between a collateralized mortgage obligation (CMO) and a mortgage-backed ...

    Find out more about collateralized mortgage obligations and mortgage-backed securities and the difference between the two ... Read Answer >>
  3. How important is credit rating on a fixed income security?

    Learn how credit ratings for fixed-income securities impact the yield and provide guidance for the amount of risk for the ... Read Answer >>
  4. Is it possible to have a credit limit that's too high?

    Avoid these pitfalls when working with high credit limits, and learn how to increase your credit score by increasing your ... Read Answer >>
  5. What's the difference between a credit rating agency and a credit bureau?

    Learn how to differentiate between credit rating agencies and credit bureaus, two industries that distribute valuable risk ... Read Answer >>
  6. In what types of financial situations would credit spread risk be applied instead ...

    Find out when credit risk is realized as spread risk and when it is realized as default risk, and learn why market participants ... Read Answer >>
Hot Definitions
  1. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  2. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  3. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  4. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  5. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  6. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
Trading Center