See Also:
Letter of Credit
Investment Banks
Double Entry Bookkeeping
Current Expenditures
Accounts PayableCollateralized Debt Obligation 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.
Collateralized debt obligations, also called collateralized bond obligations, or CBOs, are ranked with different levels of credit quality depending on the quality of the underlying debt instruments used as collateral. The different levels of credit quality are called 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. Medium credit quality collateral is used 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, depending on whether the underlying collateral debt instruments default. In the event of default, the bottom tier CDOs may not pay yields until after all higher ranking CDOs been paid in full or in part.
Collateralized Debt Obligation Example
Assume the underwriters of a CDO are going to divide the pool of debt collateral into 3 tranches: a top tranche, a middle tranche, and a bottom tranche. The tranches will be divided according to risk and the corresponding collateralized debt instruments will 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, 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, 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 that are backed by the collateral with the highest chances of default, might offer the investor a yield of 10%. This higher yield is expected to compensate the investor for the higher risk of default associated with the bottom tier CDOs.