If a debtor in the debt portfolio experiences a credit event, the equity-like
tranches are affected first: they may be only partially redeemed, or not redeemed at
all. If a number of debtors default, this affects the remaining tranches in order of
creditworthiness, until finally the tranche with the highest credit rating (comparable
to that of first-class bonds) may only be partially redeemed, or not redeemed at all.
The value of a CDO is based primarily on the probability of a credit event affecting
the individual companies in the portfolio.
This probability of default is determined
using statistical methods and on the basis of historical data, and can cease to be
meaningful in extreme market conditions.
Before you invest in a CDO, you should also look at the track record of the manager
in charge of it: he or she will receive a performance-related bonus and will often
have a holding in the CDO him/herself. If the portfolio is not run by a manager
(which is termed a “static” portfolio), its composition remains unchanged throughout
its term. In this case you should pay special attention to the composition of the
CDO typically have a term of several years. As there is generally no secondary market,
you should assume that you will not be able to sell the CDO before the end of its