A collateralised debt obligation (CDO) is a type of asset-backed security (ABS) that is backed by a pool of debt instruments, such as mortgages, bonds, or loans. CDOs are typically issued by special purpose vehicles (SPVs), which are legal entities that are set up specifically to hold the underlying assets and issue the securities.
CDOs are divided into tranches, with each tranche having a different level of risk. The most senior tranches have the lowest risk and are typically paid first in the event of a default. The most junior tranches have the highest risk and are typically paid last.
CDOs are a popular way to securitise debt. They offer a number of advantages, including:
- Portability: CDOs can be easily traded on the secondary market, which gives investors the ability to sell their investments quickly if they need to.
- Liquidity: CDOs are typically more liquid than other types of debt, which makes them easier to sell.
- Diversification: CDOs can provide investors with diversification benefits, as they are backed by a pool of different assets.
However, CDOs also have some risks, including:
- Credit risk: The underlying debt instruments may default, which could lead to losses for investors.
- Interest rate risk: The value of CDOs can be affected by changes in interest rates.
- Prepayment risk: The borrowers may prepay their loans, which could reduce the amount of income that investors receive.