Collateralized Debt Obligation (CDO) is a type of structured investment product in the form of credit-linked notes. It's a securitized product composed of a portfolio of debt obligations, including Asset-Backed Securities (ABS). Its value is derived from a basket of underlying debt assets, such as residential mortgages, credit card debts, and auto loans.
How CDO work
- Financial institutions construct a pool of funds: Financial institutions package debt assets such as residential mortgages, credit card debts, and auto loans into an asset pool.
- Asset classification: CDOs are divided into different tranches based on risk and interest rates. The future cash flows of the asset pool are divided into securities with different risk and return levels, which are then sold to investors.
- Cash flow and coupon distribution: The cash flows generated by the asset pool (such as interest and principal repayments) are distributed to investors of different tranches according to the order of priority. If some loans default and the cash collected by the CDO is insufficient to pay all investors, the lowest-level investors will suffer losses first.
Characteristics of CDOs
Diversified investment: CDOs provide investors with an opportunity to participate in a variety of debt assets, achieving portfolio diversification.
Risk-return matching: Different tranches of CDO securities have different risk and return characteristics, and investors can choose according to their own risk preferences.
Complexity and risk: CDOs have complex structures, and their value is closely related to the credit quality of the underlying assets. If the default rate of the underlying assets rises, CDO investors may face losses.
CDO are complex structured investment products that consist of complex underlying debt assets, and investors should analyze their composition in detail when investing for proper risk management.
