CDO stands for Collateralised Debt Obligation.

A CDO fund is a pooled investment vehicle which invests in a diversified group of debt assets. To finance its investments the pool vehicle issues bonds/notes to investors. The servicing and repayment of these notes is linked directly to the performance of the underlying assets.

There are a number of types of CDOs and these can be categorised according to:

1. The assets they invest in;
2. The vehicle structure and management style.

The Assets
The underlying assets can differ but the majority of CDOs invest in one or a combination of the following:

- Senior secured loans;
- Mezzanine loans;
- High yield bonds;
- Investment grade loans - these are loans rated BBB- or Baa3 and above;
- SMEs (small and medium sized enterprises), emerging markets, mortgage backed loans; and
- Asset-backed securities, including securities issued by other CDOs.

Depending on the underlying asset combination certain acronyms are often used:

- CDOs "Collateralised Debt Obligations" - implying a combination of loans and high yield
- CLOs "Collateralised Loan Obligations" - implying a loan only fund
- CBOs "Collateralised Bond Obligations" - implying a high yield fund

E.g. An investment grade CLO is a deal that invests in investment grade loans.

Structure
Some CDO deals are constructed using assets that are already present on a company's balance sheet rather than actually going out into the market place and purchasing loans. These deals are therefore called `Balance Sheet' deals.

Where the underlying assets are purchased specifically for the purpose of a pooled investment vehicle these deals are called `Arbitrage Deals'. The principle of an arbitrage deal is to issue lower yielding notes which fund the purchase of the underlying assets. The underlying assets however are higher yielding, providing an arbitrage.

There are two types of Balance Sheet CDO deals and they are:

- Cash Deals
- Synthetic Deals

Balance Sheet deals have historically been completed by banks and financial institutions that are in need of regulatory capital relief relating to the Basel capital adequacy guidelines (www.bis.org/publ/bcbsca.htm). Balance sheet deals allow the banks and financial institutions to transfer assets off their balance sheets as a way of increasing their capital capacity, improving their liquidity or as a method to create higher returns on assets through redeployment of capital.

Capital adequacy capacity is a term used to define the maximum amount of cash a bank or financial institution has to put aside to provision for its investments. Transferring assets off their balance sheet reduces their exposure, lowers the provisioning required and allows the institution to redeploy its capital and therefore increase its lending capacity.

Management Style
Some CDOs are actively managed and some CDOs are not actively managed. Broadly speaking Balance Sheet deals are NOT actively managed and Arbitrage deals ARE actively managed.

No. CDOs have been set up in the US for approximately 20 years. The first European CDOs were set up in the late 1990s. Historically the majority of these transactions have been balance sheet deals of commercial banks to obtain regulatory capital relief.

CDOs generally issue rated and unrated notes. To satisfy investors' risk-reward appetites and regulatory constraints senior notes, mezzanine notes and unrated notes are usually issued. The more "risky" or the lower the rating of the notes, the more interest they pay. This is relevant when a fund underperforms and suffers losses, as the "riskier" notes are in the "first loss" position and therefore are affected by losses.

Senior Notes
• Typically rated Aaa/AAA to A-/A3.
• These notes can be fixed or floating rate and pay a regular coupon.
• The senior notes rank in advance of all the other "debt" issued in the transaction and therefore have the highest priority on cash flows.

Mezzanine Notes
• Typically rated BBB+/Baa to B-/B3.
• These notes can also be fixed or floating rate and pay a regular coupon.
• The mezzanine debt ranks below the senior notes, but in advance of the subordinated notes.

Subordinated Notes
• These notes are not usually rated.
• The subordinated notes are often called "equity" or, in the case of Babson Capital Europe, Secured Income Notes ("SINs").
• The SINs benefit from all the residual cashflows of the transaction. This means the SINs receive all the excess cash from the current coupon payments received from underlying assets once all expenses have been paid and the senior and mezzanine debt has been serviced.
• SINs represent a leveraged investment in the underlying assets with a higher anticipated return but with increased volatility compared to the underlying assets.

Babson Capital Europe currently manages eight cash flow arbitrage CLO funds, Duchess I, Duchess III, Duchess IV, Duchess V, Duchess VI, Duchess VII, Malin and Fugu CLO, all of which invest in debt sourced in the leveraged buyout market.

Babson Capital Europe also manages one market value CLO, Rockall CLO B.V., which closed in June 2006 and also invests in debt sourced in the leveraged buyout market.

In addition, Babson Capital Europe manages several separate mandates on behalf of large institutional investors and two dedicated mezzanine funds.

Returns are generated through the difference (arbitrage) between the interest earned on the underlying assets and the interest paid on the notes. In essence, it earns higher interest on its investments than the costs of financing its notes.

In return for managing the investment portfolio of the CDO, the CDO manager receives a management fee. Such a fee is often made up of two elements, a base management fee and an incentive management fee. The base fee is usually a flat fee on the value of assets invested.

The incentive fee is strongly performance related. In the case of the Duchess CLO funds for example, this fee can only be paid out if an absolute performance level has been reached. This level, which is based on the forecast returns of the Secured Income Notes ("SINs"), is called the hurdle rate. After reaching the hurdle rate, Babson Capital Europe will receive a share of the profit generated.

In addition, Babson Capital Europe's parent MassMutual is a substantial investor in the SINs of its funds and therefore benefits directly when the funds perform well.

An asset warehouse is a loan provided by the bank arranging the CDO transaction to assist the CDO manager in purchasing assets. The warehouse loan bridges the funding requirements of the CDO fund until the portfolio of assets is large enough to generate sufficient interest receipts to warrant the issuance of the CDO's notes. This allows funds, such as Babson Capital Europe's Duchess funds, to purchase usually between 40-80% of the underlying assets before seeking financing from investors. When purchasing assets for a warehouse this is often called "warehouse ramp up".

Once a fund is between 40-80% invested or "ramped up" in the underlying assets, the fund will usually close. At this moment, referred to as the "closing", the CDO will issue notes to a) repay Bank A's warehouse facility, and b) fund further investments in the underlying assets.

The fund will continue to invest in assets or "ramp up" until it has reached its final investment amount, which is usually six to eighteen months after closing. Once this is achieved the fund will have completed its ramp up. The final investment amount, which is sometimes called the target par amount (TPA), is the total amount of the fund available for investment in the underlying assets and it is generally the total fund size minus start up costs.

Duchess I and Duchess II (which was called in April 2007), for example, are two of the largest European arbitrage CDO funds investing in debt sourced in the European loan market.

When people discuss CDOs, CLOs or CBOs they generally tend not to differentiate between the different types. By not differentiating, they are not focused on the underlying assets which dictate the performance of the fund. Some funds that have invested heavily in high yield bonds have seen a high default rate, especially in comparison to those that invest primarily in senior secured loans. Those funds that have experienced high default rates have generally underperformed, having an adverse effect on the unrated equity of the transaction.

There are few official statistics available on the European loan market, however Babson Capital Europe has experienced a comparatively low default rate to date. This is primarily because the information and reporting available to investors on individual loans is generally very good and helps highlight problems early on, thus enabling any issues to be rectified before a potential default situation.

Another comparison is often made with investment grade deals. These deals invest in investment grade assets, which are assets rated BBB- (Standard & Poor's rating) or above. The assumption that people make is that these deals are safer as they are rated higher, and therefore should be more secure. Unfortunately a number of investment grade CDO or CLO deals invested heavily in deals that have become known as the "fallen angels" such as Enron and WorldCom. When these "fallen angels" defaulted, it would have had a severe effect on the investment grade funds that were invested in them and the brunt of the impact would have been taken by the equity note holders.

Yes. There are three rating agencies - Standard & Poor's, Moody's and Fitch. Babson Capital Europe's CLO funds Duchess I-VII, Malin and Rockall are rated by Moody's and Standard & Poor's, Fugu CLO is rated by Standard & Poor's. Fund credit ratings are subject to ongoing review.

All assets are reviewed on a case by case basis by the investment team and presented to a formal credit committee. The Babson Capital Europe Credit Committee comprises of Ian Hazelton, CEO and Chairman of the Babson Capital Europe Credit Committees, David Wilmot, Zak Summerscale, Adam Eifion-Jones, Martin Horne and Stuart Mathieson.

When a company (either a public or private company) is acquired by a private equity firm, the transaction usually involves debt and or equity financing. This is called a leveraged buyout ("LBO"). The debt is a loan made to the company as part of the financing package (you could consider this to be similar to a mortgage made to a home buyer). The equity investment is usually made by the private equity house. The debt financing is provided by an "arranging" bank based in the UK or Continental Europe. The arranging bank will then take this "debt" or "loan" to other banks and financial institutions including CDO managers to see whether they would like to take and hold part of it. This process is called syndication. The institutions and funds that invest in the loans then become direct investors or lenders in the company.

There are different types of LBO related debt products. They can be distinguished in terms of type (senior bank loans, mezzanine loans, bonds), security ranking (senior secured, second secured, unsecured) and whether they are private or public instruments. The type and security ranking determine where the loan lies in the capital structure and therefore what rights the loan holder has in the event of default. The recovery rate of a loan, i.e. an assumption on the expected recovery of a loan in a default situation also varies by seniority and security ranking, as well as jurisdiction.

Yes. When a CDO fund issues its notes they are usually a combination of rated and unrated notes. The capital structure of the fund and the mix of the notes to be issued are reviewed by the rating agencies. The agencies then rate the various tranches of notes in the capital structure. The agencies continue to monitor the fund throughout its life in order to monitor the ratings of the notes.

The agencies impose a variety of restrictions on the fund which are usually called covenants. The covenants are evaluated and monitored by the fund manager and independently monitored and reported to investors by the fund's Trustee. The covenant levels usually relate to collateral mix, diversity scores, spread tests and recovery tests. They oblige the manager to invest in a portfolio diversified by industry and country and to avoid large concentrations.

E.g. Duchess I must maintain a minimum of 75% of the fund invested in senior secured loans. Therefore this prevents Duchess I from investing heavily in high yield bonds.

The primary driver for investors is their risk-reward appetite. Investors include banks, financial institutions, insurance and re-insurance companies, pension funds and family offices.

Currently the senior tranches are usually invested in by banks, financial institutions and treasury departments. The mezzanine tranches are usually invested in by banks, fund managers and insurance companies. The SIN (equity) investors are generally insurance and re-insurance companies, pension funds and family offices.

Yes, some CDOs do allow private individuals to invest. However, minimum size restrictions apply and individuals must be classified as elective professional clients.

• Through one single investment a CDO investor gains exposure to a diversified pool of assets.
• Depending on an investor's risk-return appetite, an investor can chose between a series of instruments ranging from AAA rated bonds to Secured Income Notes ("SINs").
• Because CDO funds are structured products investing in a diversified pool of assets, the actual risk-return characteristics of the senior and mezzanine notes and SINs issued by CDOs usually have a very low correlation with other assets.

If investors wanted to invest directly in loans, they would be faced with two main issues: access to the underlying assets and replicating the diversity of a CDO. The European loan market is predominantly a private market, so you can only invest if you are an active and recognised player. For the primary loan assets that Babson Capital Europe sources you have to be invited by the arranging bank to participate in the deal. The minimum transfer amounts for loans, which are set by the arranging banks, are usually in excess of €1 million which may hinder investors who wish to invest directly in loan assets.

A single investment in a CDO provides an investor with a diversified portfolio, by borrower, industry and geography. If investors were to invest directly into the asset class they would not benefit from this diversification.