Bespoke CDOs Explained: How They Work, Types, and Real-World Examples

A bespoke CDO, or bespoke collateralized debt obligation, is a structured financial product designed to meet the specific requirements of a select group of investors. Unlike traditional CDOs, which involve the sale of multiple tranches to various investors, a bespoke CDO typically comprises a single tranche purchase by the investor group. Dealers, on the other hand, retain the remaining tranches and often employ strategies such as credit derivatives to mitigate potential losses.

A bespoke CDO can be structured similarly to traditional CDOs, where various income-generating assets, such as mortgages, bonds, and loans, are pooled together. However, the term “bespoke CDO” often refers to synthetic CDOs that primarily invest in credit default swaps (CDS). These synthetic CDOs offer a higher degree of customization and complexity compared to their traditional counterparts.

In the context of CDOs, tranches represent distinct segments of the pooled assets, each carrying varying degrees of risk based on the creditworthiness of the underlying assets. Each tranche offers a different quarterly rate of return, commensurate with its risk profile. The higher the likelihood of default within a tranche’s holdings, the greater the potential return it offers. Unlike traditional CDOs, bespoke CDOs are not graded by major rating agencies but are assessed by the issuer and market perception. Due to their complexity and limited liquidity, bespoke CDOs typically trade over the counter (OTC).

Bespoke CDOs fell out of favor following their significant role in the 2007-09 financial crisis, which was triggered by the housing bubble and mortgage meltdown. They were criticized for their complexity, lack of transparency, and contribution to the market crash, leading to government bailouts. Despite their past negative reputation, bespoke CDOs have reemerged around 2016 under the new name “bespoke tranche opportunities” (BTOs).

This revival comes with a heightened focus on pricing models and due diligence to avoid the pitfalls of the past. In 2017, approximately $50 billion worth of BTOs were sold.

Understanding the mechanics of bespoke CDOs is essential to grasp their role in modern finance. These are the key steps in how bespoke CDOs work:

Dealers work closely with a specific group of investors to understand their risk tolerance, investment goals, and desired exposure. The bespoke CDO is then tailored to meet these precise specifications, ensuring it aligns with the investors’ strategy.

The dealer assembles a pool of income-generating assets. While traditional CDOs may pool mortgages, bonds, or loans, bespoke CDOs, particularly synthetic ones, often focus on credit default swaps (CDS). This pool forms the foundation of the bespoke CDO.

The pooled assets are divided into tranches, each representing a distinct level of risk. These tranches have varying rates of return corresponding to their risk profile. Investors choose a specific tranche based on their risk appetite and return expectations.

Dealers typically retain some tranches and employ financial instruments like credit derivatives to hedge against potential losses. This strategy aims to protect the dealer’s investment and maintain the bespoke CDO’s stability.

A leading player in the bespoke CDO market is Citigroup, which conducted approximately $7 billion worth of business in them in 2016. To enhance transparency in what had historically been an opaque market, Citigroup offered a standardized portfolio of credit default swaps, commonly used to construct CDOs. Additionally, the bank made the pricing structure of CDO tranches visible on its client portal, providing more transparency to clients and investors.

No, bespoke CDOs are primarily designed for sophisticated institutional investors, such as hedge funds. These investors have the expertise and risk tolerance needed to navigate the complexities and risks associated with bespoke CDOs.

The revival of bespoke CDOs, now known as BTOs, is attributed to increased scrutiny, improved pricing models, and the demand among investors to customize their risk exposure and enhance yields. Dealers have also taken steps to enhance transparency in this market.

The primary difference lies in customization and complexity. Bespoke CDOs are tailored to specific investor needs and often involve synthetic assets like credit default swaps, whereas traditional CDOs have standardized tranches and invest in various income-generating assets.

Investing in bespoke CDOs carries several risks, including regulatory concerns due to their unregulated nature, high risk due to the complexity of underlying assets, limited liquidity with a small secondary market, and challenges in pricing transparency.