Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs securities are split into different risk classes, or tranches, whereby “senior” tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.An investment-grade bond backed by a pool of junk bonds. Junk bonds are typically not investment grade, but because they pool several types of credit quality bonds together, they offer enough diversification to be “investment grade.”
Similar in structure to a collateralized mortgage obligation (CMO), but different in that CBOs represent different levels of credit risk, not different maturities. CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of Asset-backed security. To create a CDO, a corporate entity is constructed to hold assets as collateral and to sell packages of cash flows to investors. A CDO is constructed as follows:
A special purpose entity (SPE) acquires a portfolio of underlying assets. Common underlying assets held include mortgage-backed securities, commercial real estate bonds and corporate loans.
The SPE issues bonds (CDOs) in different tranches and the proceeds are used to purchase the portfolio of underlying assets. The senior CDOs are paid from the cash flows from the underlying assets before the junior securities and equity securities. Losses are first borne by the equity securities, next by the junior securities, and finally by the senior securities.
The risk and return for a CDO investor depends directly on how the CDOs and their tranches are defined, and only indirectly on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all Asset Backed Securities, enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated.
The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating and securitizing loans, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality.