Usage of Collateralized Debt Obligations (CDO) in Infrastructure Finance

Infrastructure finance is an extremely complicated and advanced field. There are many complex financial instruments related to infrastructure finance which have been created and are regularly traded between interested parties. One such financial instrument is the collateralized debt obligation (CDOs). The issuance of CDOs is the most basic way in which the principles of structured finance are applied to infrastructure finance.

In this article, we will have a closer look at what collateralized debt obligations (CDOs) are and how they help in the issuance and management of infrastructure finance.

What are Collateralized Debt Obligations?

Collateralized debt obligations (CDOs) are nothing but synthetic debt securities that are issued by an investment bank. In simple words, investment banks buy securities of many different infrastructure projects. Then, the pool all these securities together and use them as collateral to issue new securities. Therefore, the investors buying these collateralized debt obligations are holding a fraction of the debt which has been invested in several different infrastructure projects across the country or even across the world.

The basic idea behind collateralized debt obligations is that an individual infrastructure project may face an unpredictable risk profile. However, as an asset class, the infrastructure projects have a pretty stable default rate, which can be easily predicted. Hence, if several infrastructure projects are pooled together, then the securities so issued will mimic the investment profile of the entire asset class. Collateralized debt obligations are basically a mechanism to create standardized debt securities and remove the individual project risk from the bonds issued.

Certain credit enhancement techniques like tranching are often used in conjunction with the creation of collateralized debt obligations. Tranching basically protects the higher tranches of debt from default since the default hits the lower tranches first. As a result, it is possible to create high investment-grade securities out of infrastructure projects. There is a huge demand for such securities, and they are rapidly purchased by pension funds, insurance funds, and so on.

Why are Collateralized Debt Obligations Popular in Infrastructure Finance?

The debt issued by infrastructure projects is highly conducive to the issuance of CDOs. This is because a lot of infrastructure projects are backed by the government. As a result, the default rates are much lower as compared to comparable bonds issued by private corporations. Since the default rates are low, considerably less amount of money has to be spent in credit enhancement. As a result, the same credit rating can be obtained without investing too much money. CDO’s based on the cash flows from infrastructure projects are considered to be investment grade and are regularly traded in the securities markets.

Another benefit of infrastructure finance is that the number of parties involved in a project is typically small. Also, in most cases, one party cannot really benefit at the expense of the others. Hence, even if a default like situation does arise, it is in the best interest of all the parties to work together and resolve the issue as soon as possible. This increases the dependability of cash flows from infrastructure projects as such securities issued based on such projects have a higher credit rating.

How Collateralized Debt Obligations Solve An Important Need?

In the previous article, we have studied how commercial banks have the best capabilities to issue debt to infrastructure projects. They have the wherewithal required to gauge the efficiency and effectiveness of the proposed project. However, the problem is that they cannot lend long term to the infrastructure projects. This is because the liabilities of the bank are inherently short term in nature. Hence, if they use these short term liabilities to finance a long term project, they create an inherent timing mismatch.

Therefore, it would be better if banks could originate the debt and then hold it for a short period of time. Then, later on, this debt can be purchased by investment banks and sold in the securities market to investors who are looking to invest money for a longer time horizon.

The usage of collateralized debt obligations allows all parties to concentrate on what they do best. The banks can focus on origination. At the same time, the investment bankers can pool together several of these loans and then focus on increasing their credit quality. By combining cash flows of different projects across the country and even across the world, the risk of default can be brought close to zero.

Are Collateralized Debt Obligations Popular?

Collateralized debt obligations have become increasingly popular in the securities market. It is estimated that the number of infrastructure finance-related CDOs has already crossed $100 billion mark! The results of issuing collateralized debt obligations have been encouraging, to say the least. However, it can be said that the methodology for issuing CDO’s is still not well defined. It is still more art than science.

The bottom line is that collateralized debt obligations are a great way to finance infrastructure projects. They help reduce the risk while enabling several parties to meet their needs simultaneously.