Invest in Debt
The concept sounds strange at first. The idea of investing in debt seems almost like compounding a negative. Once debt has occurred, and when there are commodities, shares of company stock, or even real estate, why would someone wish to invest in debt? Yet, this concept has been popular for as long as borrowers and lenders have been working together. A signed note takes on a meaning and a value. Banks and lenders have long known how to profit from debt, and so have some private investors.
Investing in debt—a different kind of investor
When someone invests in a mutual fund, CD, or stocks, they might very well trust someone else to manage their investment. When an investor decides to put money into debt, they must be willing to study and learn about this rather unique opportunity.
Invest in Debt—Collateralized Debt Obligation (CDO)
A Collateralized Debt is created when a bank or other financial institution takes the debts owed by a collection of borrowers, and pools them together based on different risk categories. This has become an extremely controversial practice and is sometimes known as asset backed securities, or ABS. Their value comes from an underlying portfolio of fixed-income investment including mortgages, municipal bonds, corporate bonds, or any other combination.
Invest in Debt—What are Tranches?
Tranches are into what collateralized debt obligations get divided into, when being sorted by banking institutions. “Tranche” is a French word meaning slice or piece and this translates well to the concept of CDO tranches. Tranches indicate the safety of the CDO meaning the greatest possibility of a return. This comes from a variety of factors, but these criteria are already set by the time the CDO is sold. Naturally banks want a safe CDO, but usually institutions sell a variety of CDO tranches packed together so that the purchaser has to pull the safest tranche, then sell off the other tranches to get fees and profit upfront.
Invest in Debt—The Meltdown?
Banks and other groups borrow money to invest in CDOs. The people who put the packages together put lower quality assets such as from the housing boom into the tranches which was successful until the bottom dropped out of the housing market. People were unable to pay off their bills, the tranche became worthless and some banks could not repay the loans they had taken to purchase the CDOs. This was a disaster only a few very close to the market ever saw coming.
Why it is ok to invest in debt even now?
CDO’s are sophisticated tools of finance that can be sold on a secondary market. They can be a product of many different kinds of debt such as credit card, corporate, auto loans, boat loans, etc. Simply because they were part of the housing crisis does not mean they should be excluded from the wise investor’s portfolio.