Bespoke tranche opportunity : A bespoke CDO is a structured financial product—specifically, a collateralized debt obligation (CDO)—that a dealer tailors to the needs of a specific group of investors.
What Is a Bespoke CDO and How Does It Work?
The investor group typically purchases a single tranche of the bespoke CDO, with the remaining tranches held by the dealer, who will try to hedge against potential losses using other financial products such as credit derivatives.
The term “bespoke CDO” has been replaced by “bespoke tranche” or “bespoke tranche opportunity” (BTO).
Note of importance:
A bespoke CDO is a collateralized debt obligation that is tailored to the needs of a specific group of investors.
Bespoke CDOs made a comeback in 2016 under the moniker bespoke tranch opportunities, after being shunned due to their outsized role in the financial crisis of 2007-09. (BTOs).
Hedge funds and other sophisticated institutional investors are the primary users of bespoke CDOs today.
The Fundamentals of a Customized CDO
A collateralized debt obligation (CDO) traditionally pools a variety of cash flow-generating assets—such as mortgages, bonds, and other types of loans—and then repackages the portfolio into discrete tranches.
Bespoke CDOs can be structured similarly to traditional CDOs, pooling debt classes with income streams, but the term is more commonly used to describe synthetic CDOs that invest in credit default swaps (CDS) and are more customizable and nuanced.
Tranches are segments of a pooled asset that are separated by certain characteristics.
Depending on the creditworthiness of the underlying asset, different tranches of the CDO carry varying degrees of risk.
As a result, each tranche has a different quarterly rate of return based on its risk profile.
Obviously, the higher the risk of the tranche’s holdings defaulting, the higher the return.
The major rating agencies do not grade bespoke CDOs; instead, the issuer and, to some extent, market perception determine creditworthiness.
Bespoke CDOs are only traded over the counter because they are illiquid and complex financial instruments (OTC).
The History of Bespoke CDOs
Because of their prominent role in the financial crisis that followed the housing bubble and mortgage meltdown between 2007 and 2009, bespoke CDOs, like CDOs in general, have lost favour.
Wall Street’s creation of these products was blamed for contributing to the massive market crash and subsequent government bailout, as well as a lack of common sense.
The products were highly structured investments that were difficult to understand and value, both for those buying and selling them.
Despite this, CDOs are a useful tool for transferring risk to those who are willing to take it on, as well as freeing up capital for other purposes.
Wall Street is constantly on the lookout for new ways to transfer risk and free up capital.
As a result, the bespoke CDO has been making a comeback since around 2016.
It’s also known as a bespoke tranche opportunity in its new incarnation (BTO).
The tool has not changed as a result of the rebranding, but the pricing models are presumably subjected to more scrutiny and due diligence.
It is hoped that with these new products, investors will not find themselves with obligations they do not fully comprehend.
Advantages of Bespoke CDOs
The obvious benefit of a bespoke CDO is that it can be customised by the buyer.
A bespoke CDO is a tool that enables investors to target very specific risk-to-reward profiles for their investment strategies or hedging needs.
There will be a dealer who can build a bespoke CDO for an investor who wants to make a large, targeted bet against the goat cheese industry for the right price.
Nonetheless, because of the pool loans from, say, several goat cheese producers, these products are somewhat diverse.
The second major advantage is that they can provide above-market returns.
Those seeking investment income must dig deeper when credit markets are stable and fixed interest rates are low.
Cons of Customized CDOs
The fact that bespoke CDOs have little to no secondary market is a significant disadvantage.
Daily pricing is difficult due to the lack of a market. The value must be determined using sophisticated theoretical financial models.
These models can make assumptions that turn out to be disastrously incorrect, costing the owner a lot of money and leaving them with a financial instrument they can’t sell at any price.
The more customised a CDO is, the less likely it is to appeal to a different investor or investors.
Then there’s the lack of transparency and liquidity that over-the-counter transactions, in general, and these instruments, in particular, entail.
As unregulated products, bespoke CDOs carry a high risk profile, making them a better fit for institutional investors like hedge funds than for individual investors.
Bespoke CDOs in the Real World
Citigroup is a leading dealer in bespoke CDOs, having transacted $7 billion in bespoke CDOs in 2016.
To increase transparency in a market that has “historically been opaque,” as Vikram Prasad puts it.
Citi’s managing director of Correlation and Exotics Trading—Citi offers a standardised credit default swaps portfolio.
These are the assets that are typically used to construct CDOs. It also “publishes” the figures tranches fetch on its client portal, making the pricing structure of the CDO tranches visible.
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