What is a Bespoke CDO?
A bespoke CDO is a structured financial product—specifically, a collateralized debt obligation (CDO)—that a dealer creates for a specific group of investors and tailors to their needs. The investor group typically purchases a single tranche of the customized CDO, with the dealer holding the remaining tranches while trying to protect against potential losses with other financial instruments like credit derivatives.
A bespoke CDO is now more commonly called a bespoke tranche or a bespoke tranche opportunity (BTO).
The Basics of a Bespoke CDO
Traditionally, a collateralized debt obligation (CDO) pools together a collection of cash flow-generating assets—such as mortgages, bonds, and other types of loans—and then repackages this portfolio into discrete sections called tranches. Bespoke CDOs can be structured like these traditional CDOs, pooling classes of debt with income streams. Still, the term usually refers to synthetic CDOs investing in credit default swaps (CDS), which are more highly customizable and nuanced.
Tranches are portions of a pooled asset divided by specific characteristics. Different tranches of the CDO carry different degrees of risk, depending on the underlying asset’s creditworthiness. Therefore, each tranche has a different quarterly rate of return corresponding with its risk profile. Obviously, the greater the chance of default on the tranche’s holdings, the higher the return it offers. The major rating agencies do not grade bespoke CDOs—the creditworthiness evaluation is done by the issuer and, to some extent, market perception. Because these are illiquid and complex financial instruments, bespoke CDOs only trade over-the-counter (OTC).
Background of Bespoke CDOs
Bespoke CDOs—like CDOs in general—have lost popularity due to their prominent role in the financial crisis that followed the housing bubble and mortgage meltdown between 2007 and 2009. Wall Street’s creation of these products was seen as contributing to the massive market crash and eventual government bailout, as well as a lack of common sense. The products were highly structured investments that were hard to understand—both by those buying and those selling them—and difficult to value.
Despite this, CDOs are valuable for transferring risk to parties willing to shoulder it and freeing up capital for other uses. Wall Street is always looking for ways to transfer risk and unlock capital. So, since around 2016, the bespoke CDO has been returning. In its reincarnation, it’s often called a bespoke tranche opportunity (BTO).
Re-branding has not changed the tool itself, but there is presumably a bit more scrutiny and due diligence going into the pricing models. It is hoped that with these new products, investors won’t find themselves holding obligations they don’t understand correctly again.
Pros of Bespoke CDOs
The apparent advantage of a bespoke CDO is that the buyer can customize it. A bespoke CDO is a tool that allows investors to target particular risk-to-return profiles for their investment strategies or hedging requirements. If an investor wants to make a significant, targeted bet against the goat cheese industry, there will be a dealer who can build up a bespoke CDO to do that for the right price. Still, these products are somewhat diversified since the pool loans from, say, several goat cheese producers.
The second main benefit is the above-market yields they can provide. When the credit markets are steady and fixed interest rates are low, those seeking investment income must dig deeper.
Cons of Bespoke CDOs
The significant disadvantage is that there is typically little to no secondary market for bespoke CDOs. This lack of market demand makes daily pricing difficult. The value must be calculated based on complex theoretical financial models. Those models can make catastrophically wrong assumptions, costing the holder dearly and leaving them with a financial instrument they cannot sell at any price. The more customized the CDO, the less likely it will appeal to another investor or investors.
Then, the lack of transparency and liquidity accompanies over-the-counter transactions and these instruments in particular. As unregulated products, bespoke CDOs remain relatively high on the risk scale—more suitable for institutional investors, like hedge funds, than individuals.
- Customized to investor specs
- High-yielding
- Diversified
- Unregulated
- High-risk
- Illiquid (small secondary market)
- Opaque pricing
Real-World Example of Bespoke CDOs
Citigroup is one of the leading dealers in bespoke CDOs, doing US $7 billion worth of business in 2016 alone. To increase transparency in what “has historically been an opaque market”—to quote Vikram Prasad Citi’s managing director of correlation and exotics trading—the bank offers a standardized portfolio of credit default swaps. These are the assets usually used to build the CDOs. It also makes the CDO tranches’ pricing structure visible on its client portal, “publishing” the figures the tranches fetch.
Conclusion
- A bespoke CDO is a collateralized debt obligation customized to the specific needs of a particular group of investors.
- Shunned due to their outsized role in the 2007–09 financial crisis, bespoke CDOs began reappearing in 2016 under the moniker bespoke tranche opportunities (BTOs).
- Today, hedge funds and other sophisticated institutional investors mainly utilize bespoke CDOs.
