Page 87 - FINAL CFA SLIDES DECEMBER 2018 DAY 14

Session Unit 15:
53. Introduction To Asset-Backed Securities

An investment in the equity or residual tranche can be viewed as a leveraged investment where
borrowed funds (raised from selling the senior and mezzanine tranches) are used to purchase the
debt securities in the CDO’s collateral pool. To the extent the collateral manager meets his goal of

earning returns in excess of borrowing costs (the promised return to CDO investors), these excess
returns are paid to the CDO manager and the equity tranche.

The CDO structure typically is to issue a floating-rate senior tranche that is 70–80% of the total and a
smaller mezzanine tranche that pays a fixed rate of interest. If the securities in the collateral pool pay
tanties
a fixed rate of interest, the collateral manager may enter into an interest rate swap that pays a
floating rate of interest in exchange for a fixed rate of interest in order to make the collateral yield

more closely match the funding costs in an environment of changing interest rates. The term
arbitrage CDO is used for CDOs structured to earn returns from the spread between funding costs
and portfolio returns.

The collateral manager may use interest earned on portfolio securities, cash from maturing portfolio

securities, and cash from the sale of portfolio securities to cover the promised payments to holders
of the CDOs senior and mezzanine bonds.