A Collateralized Debt Obligation (CDO) is a type of structured asset-backed security (ABS) that is commonly associated with the real estate investment industry. Originally developed for the corporate debt markets, it became widely used in mortgage and mortgage-backed security markets.
At its core, a CDO is a complex financial product that groups together various cash-flow generating assets, such as bonds and loans, and repackages these income streams into discrete tranches that can be sold to investors. The majority of CDOs in the real estate sector typically contain a diverse portfolio of mortgage-backed securities (MBS) which are in turn backed by residential or commercial mortgages.
The tranches in a CDO differ in their risk profile and yield. The senior tranches are considered the least risky because they have the first claim on the cash flows from the underlying assets. They are typically rated as investment-grade by credit rating agencies and offer lower yields. The junior tranches, in contrast, are more risky, have a subordinate claim on the cash flows, are often rated below investment grade (or not rated at all), and offer higher potential yields to compensate for the additional risk. In some cases, there is a third type, the equity tranche, which is the most risky and is the last in line to receive cash flows.
During the financial crisis of 2007-2008, CDOs tied to subprime mortgages were a significant factor in the global economic downturn. They were often marketed as low-risk investments, but as housing prices declined and mortgage default rates rose, many of these CDOs experienced significant losses. Therefore, while CDOs can offer investors the opportunity to earn returns from a diverse portfolio of debt, they also entail significant risks that must be carefully managed.