Synthetic CDO

AAA

DEFINITION of 'Synthetic CDO'

A form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other non-cash 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.

All tranches will receive periodic payments based on the cash flows from the credit default swaps. 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.

INVESTOPEDIA EXPLAINS 'Synthetic CDO'

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.

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.

VIDEO

Loading the player...
RELATED TERMS
  1. Collateralized Loan Obligation ...

    A security backed by a pool of debt, often low-rated corporate ...
  2. Forward Contract

    A customized contract between two parties to buy or sell an asset ...
  3. Collateralized Debt Obligation ...

    An investment-grade security backed by a pool of bonds, loans ...
  4. Bespoke CDO

    A type of collateralized debt obligation (CDO) that a dealer ...
  5. Credit Default Swap - CDS

    A swap designed to transfer the credit exposure of fixed income ...
  6. Collateralized Bond Obligation ...

    An investment-grade bond backed by a pool of junk bonds. Junk ...
Related Articles
  1. Investing Basics

    CMO vs CDO: Same Outside, Different Inside

    The concept of collateralizing and structured financing predates the market for collateralized mortgage obligations and collateralized debt obligations.
  2. Options & Futures

    Massive Hedge Fund Failures

    Flying high one day but not the next - see the stories behind some spectacular meltdowns.
  3. Mutual Funds & ETFs

    Who Is To Blame For The Subprime Crisis?

    From lenders to buyers to hedge funds, it appears everyone has blood on their hands.
  4. Personal Finance

    The Fuel That Fed The Subprime Meltdown

    Take a look at the factors that caused this market to flare up and burn out.
  5. Insurance

    Futures Fundamentals

    For those who are new to futures but want a solid understanding of them, this tutorial explains what futures contracts are, how they work and why investors use them.
  6. Options & Futures

    Examples Of Exchange-Traded Derivatives

    We look at some of the most common exchange-traded derivatives.
  7. Options & Futures

    Advantages Of Trading Futures Over Stocks

    We look at the top eight advantages of trading futures over stocks.
  8. Bonds & Fixed Income

    Should Junk Bond ETFs Be a Part of Your Portfolio?

    Should junk bonds be a part of your portfolio? Here's what you need to know.
  9. Professionals

    Vanguard Readies Muni Bond ETF

    Vanguard is set to roll out a muni bond ETF, the firm's first.
  10. Mutual Funds & ETFs

    Is the TLT ETF a Good Bet for the Long Run?

    Is the iShares 20+ Year Treasury Bond ETF (TLT) a good bet for the long run?

You May Also Like

Hot Definitions
  1. Hurdle Rate

    The minimum rate of return on a project or investment required by a manager or investor. In order to compensate for risk, ...
  2. Market Value

    The price an asset would fetch in the marketplace. Market value is also commonly used to refer to the market capitalization ...
  3. Preference Shares

    Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a ...
  4. Accrued Interest

    1. A term used to describe an accrual accounting method when interest that is either payable or receivable has been recognized, ...
  5. Absorption Costing

    A managerial accounting cost method of expensing all costs associated with manufacturing a particular product. Absorption ...
  6. Currency Carry Trade

    A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase ...
Trading Center