Cash CDOs are collateralized by a portfolio of cash assets and the entire liability structure is used to fund the purchase of collateral. Synthetic CDOs transfer credit risk from the CDO issuer to CDO note holders through CDS. The synthetic CDO normally funds only a small portion of the notional value of the credit exposure. Therefore the weighted average cost of liabilities are much smaller for a synthetic CDO because of the unfunded super senior tranche (around 85–90 percent of the capital structure) which leads to a higher return on the equity tranche.
Other advantages of synthetic CDOs are as follows:
- diversify away from frequent issuers in the bond market
- no restrictions in terms of volume
- ability to tailor maturity.
A synthetic CDO referencing investment grade CDS can be structured with much higher leverage compared to a high-yield CBO. The equity in a synthetic deal normally ranges from 2 to 5 percent, which equates to 20–50 times leverage. Equity in a high-yield CBO is around 10 percent on average (10 times leverage).