I’m trying to understand the difference between an ABS and a CDO. Is a CDO a type of f Asset Backed Security?
ABS is a type of bond backed by pool of assets. CDO is a pool of debt instruments (usually ABS), and these instruments are divided into various tranches depending on their risk-return profile. An investor can invest in a CDO, and decide which tranche he wants to be in.
Thanks, Aby. I guess what was confusing me is that a CDO is also backed by a pool of assets. So an ABS refers to a single bond, and a CDO consists of a pool of bonds divided into tranches characterized by different repayment risk. Correct?
CDO’s are usually not created for prepayment risk but for credit risk. The credit losses go first to the most junior tranche (equity) and then up the line to the most senior tranche (“super-senior”). A CDO is usually an asset-backed security (although at the extremes of unfunded synthetic CDO’s and revolving “market-value” CDO’s, there is a legal question I don’t know the answer to). An asset backed security is just about anything which has some terminal payout and is serviced by the cash flows from some underlying assets. It does not have to be tranched.
Thanks, Joey. That helps a lot. The CFAI material did not go into much detail on this stuff. Must be saving it all for Level 2!
My understanding of it is that asset backed are secured by the assets while the CDO are ‘secured’ if you can say that by the credit given to the financial company that issues it.
Depends on the CDO. In unsecured structures, the big liabilities might even lie with the purchasers of the CDO. L II has lots more stuff about structured finance than L I.