Market Value
A market value approach can be used to help estimate the value of lower rated CBOs. The market value approach looks at the amount by which proceeds from immediate collateral sales would exceed the par value of the liabilities. In the case where a substantial excess market value exists to support the defeasance of the CBO class at par, the bond cash flows can be estimated and present valued at a reasonable discount rate to arrive at an approximate price.

With the market value approach, the more generic collateral bonds with no credit problems can be easily priced using pricing services or generic spread pricing. Bonds with short credit options that are in the money, or bonds that have been downgraded, should be segregated and be more carefully priced. These bonds are more likely to result in the marginal capital losses that could lower the value of the collateral relative to the par value of the CBO bonds, and diminish the prospects for market value defeasance at par. In some cases, scenario analysis must be used to price credit sensitive securities with poor performance prospects to consider more carefully the expected cost of the default option. We recommend using a probability weighted scenario price in these instances.

Cash Flow
Subjective estimates of collateral cash flows over time net of expected credit losses can be used to gauge the cash flow and price of the various CBO classes. Estimating the cash flows likely for each class of lower rated CBO bonds can be tricky if the market value of the assets is near to or lower than the par value of the CBO liabilities. This implies that credit performance may cause one or more of the lower classes not to receive its scheduled coupon and principal repayments over time. It also presents the likelihood that various triggers are active and redirecting lower rated cash flows to the most senior CBO debt classes issue. Active triggers can alter or preempt, entirely, the rights of a lower rated bond to collateral cash flows in the foreseeable future. If the prospects for remedying this trigger through bond sales or by using excess interest to restore OC levels are not good, the value of the lower rated CBO classes may be dramatically lower than its par value.

When lower rated CBO bonds are likely to face shortfalls, manager actions could alter the value of the bonds. While managers are generally required to take actions that enhance the value of the senior bonds, triggers and tests may impose conflicting requirements that make it difficult to assess how the structure will perform.