Does SPV have to invest in government bonds, as suggested by the solution to the Q3 on the mock? My original undersdanding was that the investments under SPVs will be divided by the profile of risk - similar to the CDO.
There is a difference between the two in terms of how they work relating to the context, for a CDO yes they may invest in tranches, for a CLN as is the question. The idea is to offer protection to the protection buyer via CDS with a guarantee see bullet 3 page 8 of the mock solution.
It all depends on the purpose of creating the SUV. For example, if the SPV is created to securitize the existing pool of assets (say corporate), it only needs to purchase CDS (to enhance credit profile of the pool of asstes) and then create tranches for selling to the investors. On the other hand, if the assets base does not exist, say when the insurer wants to issue a cat bond/survival bond (whose cash-flows will vary by experience of respective risks), in those scenarios, the promoter will invite investors to invest in the SPV, and there he may decide how to tier the tranches to sell.Once he receives sufficient funding, then he has to invest part or whole of the funds in govt. bonds (or AAA bonds) to maintain credit profile of the SPV backed debt. In case whole of the investment in govt bonds, then whenever a shortfall happens in the cashflows from the promised ones, the promoter has to chip in with bridge funding.
Some good replies already, thanks ST9 students! Basic answer is No. In the simple example in the notes, the SPV is investing in a risk-free asset to ensure it has assets available to payout on the CDS if required. It could invest in riskier assets to generate higher yield for investors (in addition to the spread on the reference bond) but this introduces extra risk for the SPV, and hence counterparty risk for the protection buyer (in which case they might be better buying a CDS from some other party).
