A collateralized debt obligation derivative, or CDO, is an investment grade debt instrument backed by collateral consisting of loans or other debt instruments. The collateral typically consists of bonds with varying degrees of credit quality and risk.
You can also call collateralized debt obligations collateralized bond obligations or CBOs. Rank them with different levels of credit quality depending on the quality of the underlying debt instruments used as collateral. Call the different levels of credit quality tiers or tranches.
Underwriters pool the collateral according to risk and credit quality. The highest quality collateral backs the top tranche CDOs. Those collateralized debt obligation derivatives offer the lowest returns to the investor. In comparison, use medium credit quality collateral to back middle tier CDOs. These collateralized debt obligations offer returns above the top tier CDOs but below the bottom tier CDOs. The lowest quality collateral backs the bottom tier CDOs. These collateralized debt obligations are the riskiest. They may pay the highest returns to the investor, or they may pay nothing. It all depends on whether the underlying collateral debt instruments default. In the event of default, you must pay all higher ranking CDOS in full or in part. As a result, the bottom tier CDOs may not pay yields.
Assume the underwriters of a CDO are going to divide the pool of debt collateral into the following 3 tranches:
The middle tier CDOs, or the collateralized debt obligation instruments with medium risk that are backed by the collateral that has mediocre chances of default, then it would offer the investor a slightly higher return to compensate for the slightly higher risk. So these middle tier CDOs might offer a yield of 7.5%.
And finally the bottom tranche CDOs – the collateralized debt instruments with the highest risk, backed by the collateral with the highest chances of default – might offer the investor a yield of 10%. As a result, expect this higher yield to compensate the investor for the higher risk of default associated with the bottom tier CDOs.