What is a Collateralized Debt Obligation?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 05 May 2020
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A collateralized debt obligation is any investment that is backed by a collection of several different assets. Often, this collection of backing assets will include bonds or bank loans that are not classified as mortgages. This arrangement does create a higher degree of risk for the investor, as there is the chance of default on the loans backing the investment. In return for assuming this higher risk, the investor stands a chance of realizing a higher rate of return on the investment.

The collateralized debt obligation, or CDO, is considered to be an investment-grade security. With this type of security, there is some type of debt or equity present. The debt of equity is backed by a stable organization that is considered solvent and reputable. An investor is willing to assume the higher risk associated with the debt or equity in anticipation of receiving compensation as the debt is repaid.

CDOs typically do not use a single type of debt as the backing for the obligation. Instead, there is usually a mixture involved, with several debt instruments used to back a single obligation. In effect, when an investor makes a purchase into a collateralized debt obligation, he or she is buying an interest into several debt instruments at one time. The cumulative amount of risk involves depends on the amount of individual risk associated with each instrument used in the deal.

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 does allow the investor access to any profit that is made from the instruments involved. For investors who do not wish to directly purchase and service debts, the use of a collateralized debt obligation is a great option.

Generally, the debt that is used to back the collateralized debt obligation is mixed. That is, various debts will have different maturity dates and 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 mixing of debts, it is possible for an investor to find some examples of CDOs that carry less risk than others.

While a collateralized debt obligation is usually defined as an investment that is backed by a group of different debts, the term is sometimes employed in a broader manner. 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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