Investopedia defines a Collateralized Debt Obligation as:
"A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors."
A type of structured Asset-Backed Security (ABS) is used for Collateralized Debt Obligation (CDO). Originally it was for debt markets of corporate level but with the passage of time it evolved into encompassing the mortgage and also Mortgage-Backed Security (MBS) markets.
It is a structured financial product or synthetic investment that handles the pooling of cash flow-generating assets together and then afterwards repackages the asset pool into discrete tranches (a tranche is a portion of something, especially money) that are further going to be sold to investors.
The term collateralized debt obligation (CDO) is used because the pooled assets such as bonds, loans and mortgages are essentially obligations of debt that serve as CDO collateral. In the risk profile of CDO, the tranches vary substantially.
As a private security backed by assets, CDO can be said to be a promise for investors to pay in a prescribed sequence which is based on the flow of cash the CDO gathers from its pool of bonds or similar assets that it has.
A CDO is partitioned in the form of tranches which then gather the interest flow of cash and payments in a sequence that is based on seniority. The basic division of tranches is in three, and each one is a separate CDO.
All of these are different from each other with respect to interest rate, maturity and default risk. If the collected cash of CDO is insufficient to pay all investors and some loans default, the lowest most "junior" tranches suffer losses first. In this way, the last ones to suffer losses are the senior tranches which are the safest. On the other hand, payments of coupons vary by tranches. The senior/safest pay the lowest rates while the junior/risky pay the highest rates.
The first priority on the collateral in the event of default is given to senior tranches which are relatively safer compared to juniors. As a result, generally senior tranches have higher ratings on credit so they offer coupon rates which are comparatively lower than junior tranches, which have higher coupon rates to compensate towards their higher risk of default.
As an example of this statement, we can put this in simpler terms such as there are three tranches, which are namely A, B and C. Here, A is senior to B, and B is senior to C.
There are basically five parties that are involved in the construction of Collateralized Debt Obligations namely security firms, CDO managers, rating agencies, financial guarantors, and investors.
Security firms approve the collateral selection structure the notes into tranches before selling them to investors. CDO managers select collateral and manage the CDO portfolios. Rating agencies provide fiscal assessments for CDOs, and assigns them credit ratings based on their performance. Financial guarantors take premium payments to give promise of reimbursing investors for any and all loses on the CDO tranches. Investors provide pension funds and hedge funds.
Special Purpose Entities (SPE) issues CDOs and they pay the investors. Upon development, a few sponsors' repackaged tranches in another iteration called "CDO squared" or "CDOs of CDOs."
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Jimmy explains the need to avoid debts in the corporate world. His product "The Debt Crusher" is a guide for perosnal finance managemnt, but can be also used to delineate investment options and is good advice for small business and big business alike.
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