A collateralized debt obligation (CDO) is an investment backed by multiple debt instruments, including bonds and bank loans. The mix of debt instruments creates varying degrees of risk and potential returns for investors. CDOs do not transfer ownership of the debt instruments but allow investors to access their benefits. The term is sometimes used more broadly to identify any type of collateralized obligation.
A collateralized debt obligation is any investment backed by a collection of several different assets. Often this collection of supporting assets will include bonds or bank loans that are not classified as mortgages. This arrangement creates a higher degree of risk for the investor, since there is the possibility of default on the loans that back the investment. In exchange for assuming this increased risk, the investor has the possibility of earning a higher rate of return on the investment.
The collateralized debt obligation, or CDO, is considered an investment grade collateral. With this type of security, there is some form of debt or equity present. The equity debt is backed by a stable organization that is considered solvent and in good standing. An investor is willing to take the increased risk associated with debt or equity before receiving compensation as the debt is paid off.
CDOs generally do not use a single type of debt to back the obligation. Instead, there is usually a mix involved, with various debt instruments used to back a single obligation. In effect, when an investor makes a purchase of a collateralized debt obligation, he is buying an interest in several debt instruments at the same time. The cumulative amount of risk involved depends on the amount of individual risk associated with each instrument used in the agreement.
It is important to note that a collateralized debt obligation does not actually transfer ownership of the debt instruments to the investor. However, the activity allows the investor to access any benefit obtained from the instruments involved. For investors who do not want to buy and pay debt directly, using a collateralized debt obligation is a great option.
In general, the debt used to back the collateralized debt obligation is mixed. That is, various debts will have different due dates and will carry varying degrees of risk. The amount of interest paid on each of the debts depends on how much risk is associated with each debt included in the obligation. Because of this type of debt mix, an investor may find some examples of CDOs carry less risk than others.
While a collateralized debt obligation is generally defined as an investment backed by a group of different debts, the term is sometimes used more broadly. In some circles, a collateralized debt obligation is used as a general term to identify any type of collateralized obligation, including loans, mortgages, or bonds.
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