Collateralized Debt Obligations
Collateralized Debt Obligations

See Also:
Letter of Credit
Investment Banks
Double Entry Bookkeeping
Current Expenditures
Accounts Payable

Collateralized Debt Obligations Definition

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.

Collateralized Debt Obligation 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.

Collateralized Debt Obligation Example

Assume the underwriters of a CDO are going to divide the pool of debt collateral into the following 3 tranches:

  • A top tranche
  • A middle tranche
  • A bottom tranche.

Divide the tranches according to risk. The corresponding collateralized debt instruments will then offer returns reflecting the degree of risk in the underlying collateral.
If the top tier CDOs, or the collateralized debt obligation derivatives, with the least risk that are backed by the collateral that has the lowest chances of default, then it offers a yield of 5%.
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.
collateralized debt obligations

ARTICLES YOU MIGHT LIKE

Mining the Balance Sheet for Working Capital

Mining the Balance Sheet for Working Capital Let’s face it… There has been significant liquidity in the marketplace over the past couple of years. Debt and equity capital has been relatively easy to find and commercial banks have been very willing participants as capital providers; however, many of the commercial banks have admitted that this robust marketplace

Read More »

Is Your Business Bankable?

Businesses call us for many reasons but here are two very common reasons why we get called… They are growing and want to strengthen the financial function. OR They are in financial distress and can’t find a way out. Why does a business need to be bankable? What does being bankable mean? In this blog,

Read More »

Alternative Forms of Financing

It happens all the time. Companies need capital, but they aren’t bankable. Banks or other financial institutions will not touch them because they are either too risky, not able to meet covenants, or it just doesn’t work out for some reason. So, where do those companies go? They need to look at alternative forms of

Read More »

JOIN OUR NEXT SERIES

Financial Leadership Workshop

MARCH 28TH-31ST 2022

THE ART OF THE CFO®

Financial Leadership Workshop

Days
Hours
Min

June 12-15th, 2023

SHARE THIS ARTICLE
WIKI CFO® - Browse hundreds of articles