Collateralized Debt Obligation (CDO)

What Is a Collateralized Debt Obligation (CDO)?

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors.

A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.

Understanding Collateralized Debt Obligations (CDOs)

The earliest CDOs were constructed in 1987 by the former investment bank, Drexel Burnham Lambert — where Michael Milken, then called the "junk bond king," reigned. The Drexel bankers created these early CDOs by assembling portfolios of junk bonds, issued by different companies. CDOs are called "collateralized" because the promised repayments of the underlying assets are the collateral that gives the CDOs their value.

Ultimately, other securities firms launched CDOs containing other assets that had more predictable income streams, such as automobile loans, student loans, credit card receivables, and aircraft leases. However, CDOs remained a niche product until 2003–04, when the U.S. housing boom led CDO issuers to turn their attention to subprime mortgage-backed securities as a new source of collateral for CDOs.

Collateralized debt obligations exploded in popularity, with CDO sales rising almost tenfold from $30 billion in 2003 to $225 billion in 2006. But their subsequent implosion, triggered by the U.S. housing correction, saw CDOs become one of the worst-performing instruments in the subprime meltdown, which began in 2007 and peaked in 2009. The bursting of the CDO bubble inflicted losses running into hundreds of billions of dollars for some of the largest financial services institutions. These losses resulted in the investment banks either going bankrupt or being bailed out via government intervention and helped to escalate the global financial crisis, the Great Recession, during this period.

Despite their role in the financial crisis, collateralized debt obligations are still an active area of structured finance investing. CDOs and the even more infamous synthetic CDOs are still in use, as ultimately they are a tool for shifting risk and freeing up capital — two of the very outcomes that investors depend on Wall Street to accomplish, and for which Wall Street has always had an appetite.

The CDO Process

To create a CDO, investment banks gather cash flow-generating assets — such as mortgages, bonds, and other types of debt — and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.

These tranches of securities become the final investment products, bonds, whose names can reflect their specific underlying assets. For example, mortgage-backed securities (MBS)are comprised of mortgage loans, and asset-backed securities (ABS) contain corporate debt, auto loans, or credit card debt.

Other types of CDOs include collateralized bond obligations (CBOs) — investment-grade bonds that are backed by a pool of high-yield but lower-rated bonds, and collateralized loan obligations (CLOs) — single securities that are backed by a pool of debt, that often contain corporate loans with a low credit rating. 

Collateralized debt obligations are complicated, and numerous professionals have a hand in creating them:

CDO Structure

The tranches of CDOs are named to reflect their risk profiles; for example, senior debt, mezzanine debt, and junior debt — pictured in the sample below along with their Standard and Poor's (S&P) credit ratings. But the actual structure varies depending on the individual product.

Image by Sabrina Jiang © Investopedia 2020

In the table, note that the higher the credit rating, the lower the coupon rate (rate of interest the bond pays annually). If the loan defaults, the senior bondholders get paid first from the collateralized pool of assets, followed by bondholders in the other tranches according to their credit ratings; the lowest-rated credit is paid last.

The senior tranches are generally safest because they have the first claim on the collateral. Although the senior debt is usually rated higher than the junior tranches, it offers lower coupon rates. Conversely, the junior debt offers higher coupons (more interest) to compensate for their greater risk of default; but because they are riskier, they generally come with lower credit ratings.

Senior Debt = Higher credit rating, but lower interest rates. Junior Debt = Lower credit rating, but higher interest rates.

How Are Collateralized Debt Obligations (CDO) Created?

To create a collateralized debt obligation (CDO), investment banks gather cash flow-generating assets — such as mortgages, bonds, and other types of debt — and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor. These tranches of securities become the final investment products, bonds, whose names can reflect their specific underlying assets.

What Should the Different CDO Tranches Tell an Investor?

The tranches of a CDO reflect their risk profiles. For example, senior debt would have a higher credit rating than mezzanine and junior debt. If the loan defaults, the senior bondholders get paid first from the collateralized pool of assets, followed by bondholders in the other tranches according to their credit ratings with the lowest-rated credit paid last. The senior tranches are generally safest because they have the first claim on the collateral. 

What Is a Synthetic CDO?

A synthetic CDO is a type of collateralized debt obligation (CDO) that invests in noncash assets that can offer extremely high yields to investors. However, they differ from traditional CDOs, which typically invest in regular debt products such as bonds, mortgages, and loans, in that they generate income by investing in noncash derivatives such as credit default swaps (CDSs), options, and other contracts. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed by the investor.