Loading the player...

What is a 'Synthetic CDO'

A synthetic CDO is a collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other noncash assets to obtain 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.

Synthetic CDOs and Tranches

Tranches are also known as slices of credit risk between risk levels. Normally, the three tranches primarily used in CDOs are 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. The bank can create 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 includes 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 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 ...

    Collateralized debt obligations (CDOs) are investment-grade securities ...
  2. Warehousing

    Warehousing is an intermediate step in a collateralized debt ...
  3. Synthetic ETF

    A synthetic ETF (exchange-traded fund) mimics the behavior of ...
  4. Bespoke CDO

    A bespoke CDO is a customized structured financial product created ...
  5. Synthetic Biology

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

    A tranche of a collateralized mortgage obligation (CMO) that ...
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. Investing

    Down The Rabbit Hole: Deciphering CDOs

    Warren Buffett claims that understanding these instruments would mean reading 750,000 pages of text. Read on to learn the basics.
  3. Investing

    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.
  4. Insights

    The Fuel That Fed The Subprime Meltdown

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

    Get Positive Results With Negative Basis Trades

    Capitalize on the difference in spreads between markets with this popular strategy.
  6. Insights

    Falling Giant: a Case Study of AIG

    Find out why the U.S. government approved an enormous bailout package for American Investment Group (AIG).
  7. Insights

    'The Big Short' explained

    Oscar-nominated film "The Big Short" explains the complex financial instruments that helped fuel the financial crisis of 2008-09.
  8. Investing

    Valeant Announces New Debt Offering

    Valeant is offering new debt securities to repay some outstanding ones. Is it just buying itself more time?
  9. Investing

    The Fed's Tools for Influencing the Economy

    The economy can be volatile when left to its own devices. Find out how the Fed smoothes things out.
  10. Investing

    What is a Collateralized Loan Obligation?

    A collateralized loan obligation (CLO) is a security consisting of a pool of loans organized by maturity and risk.
RELATED FAQS
  1. Collateralized Debt Obligation (CDO) vs Asset Backed Security (ABS)

    Understand the differences in relationships between asset-backed securities (ABS), collateralized debt obligations (CDOs), ... Read Answer >>
  2. Why do banks securitize some debts, and how do they sell them to investors?

    Learn how and why banks securitize debt, how the securitized debt is sold to other investors, and how different the different ... Read Answer >>
  3. Who Bears the Risk of Bad Debts in Securitization?

    Bad debts arise when borrowers default on loans. But that risk can be split up in different ways. Read Answer >>
  4. What role did junk bonds play in the financial crisis of 2007-08?

    Discover the role that junk bonds played in the financial crisis of 2007-2008. The main issue is that toxic housing debt ... Read Answer >>
  5. 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 >>
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  3. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  4. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  6. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
Trading Center