Structuring a CDO

You are an asset manager and you want to structure a CDO (collateralized debt obligation) to generate above average return for the subordinate/equity tranche. You want to create a US$100 million CDO from (non-callable) collateral of 10 year coupon paying bonds that all mature in 10 years and pay a floating interest rate (coupon) of 10-year US Treasury Note plus 400 basis points. The CDO tranches are shown below:

Further, you find out from your banker that if you were to do an interest rate swap on an amount up to US$100 million with 10 year maturity you would be able to pay fixed 10-yr US Treasury Note plus 100 bps and receive LIBOR. Your fees for this transaction would be around 0.94% of the total of notional of senior and mezzanine amount. Assume that the current 10 year US Treasury Note rate is 4.00%.

What kind of return (return on assets) will you be able to generate from the subordinate/equity tranche of this CDO? If you can get around 10% return by investing in an alternative portfolio would you rather not do this CDO transaction?

Solution:

The return on the subordinate/equity tranche will be around 16.50% and therefore you are better off structuring this CDO than investing in an alternative portfolio that generates 10% return.

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