Collateralized Debt Obligations (CDO’S) – Understanding Collateralized Debt Obligations

When looking at investment options, you may have come across the term collateralized debt obligations or CDO.

What are collateralized debt obligations? This is an investment security with underlying bonds, loans, and other collateralized debt. They generally do not contain mortgage loans or bonds. The mixture completely depends on the particular CDO in question. Depending on the particular CDO, the mixture contains a good blend of debts with different maturity dates and differing risks associated with them. The higher the risk that the overall CDO presents, the more it will pay to the investor in the long term.

Before the recent economic issues, many CDOs contained mortgage backed loans in their mix. The number of CDOs grew a great deal before 2007. During the mortgage bust in the US, many of these collateralized debt obligations lost a great deal of their value. Today, there are fewer of these instruments available on the market. And the vast majority does not have mortgage backed securities in their portfolio.

You will find there are multiple forms of collateralized debt obligations from which you can select if you choose to go with this investment option. There are four primary forms of these obligations:

  1. Collateralized loan obligations (CLO) have leveraged bank loans as their main underlying asset.
  2. Collateralized synthetic obligations (CSO) have a mixture of credit derivatives as their underliers.
  3. Structured finance CDOs are those backed by asset backed securities and mortgage backed securities
  4. Collateralized bond obligations (CBO) are backed by fixed income assets.

Each of these brings their own mixture of benefits and risks to the average investors. Before the mortgage bust, most of these products fell into the structured finance area or the CLO area. Today, the mixture is much diversified.

Typical collateralized debt obligations are an offering of an investment bank. The bank structures the CDO with a mixture of debt obligations. They determine what level of risk they will present to the investor. The new CDO goes to the credit rating agencies to see what ratings will go with each underlying investment. When it’s ready, the bank appoints an asset manager to keep the CDO on track. The investors then get the chance to buy the financial instrument as an investment.

Before investing in collateralized debt obligations, it is important to know exactly what the CDO offers as well as the associated risks. Speaking with investment professionals is a good way to get that information clearly.

About Richard Wilson