INSURANCE AND THE ADVANTAGES OF CDO EQUITY
CDOs provide access to a host of assets that investors cannot easily gain exposure to, either because of liquidity or rating constraints. As previously mentioned, these assets include leveraged loans, noninvestment-grade bonds, residential subprime mortgages, and commercial real estate loans.
By providing access to these assets, CDOs deliver diversification benefits that expand the efficient frontier. In cases where the pool of financial assets is not static, but rather managed by a portfolio manager, CDO equity gives investors access to a manager’s expertise.
CDO structures do not manufacture diversification. CDO equity returns are closely linked to the performance of the underlying assets. They will not be perfectly correlated with the underlying asset performance because of structural provisions that affect the way the collateral cash flows are distributed to equity.
CDO equity offers high dividend payments that are typically front-loaded. The investment typically competes for capital with private equity and hedge funds. CDO equity offers far greater transparency than either of these two asset classes. With CDOs, the funding costs and cash flow allocation rules are known. Moreover, there is a trustee and regular surveillance through which investors can know the contents of a manager’s portfolio. In addition, the rating agencies closely monitor the CDO market and publish regular reports.