What is a Collateralized Bond Obligation?

A collateralized Bond Obligation (CBO) refers to an investment-grade asset that is backed by assets that are not investment-grade, otherwise called junk bonds. The pool of junk bonds that back a CBO often have high risks, the higher their risks, the higher the interest rates an investor will earn on the CBO. Usually, the junk bonds that back a CBO have different levels of risks which aid diversification of the asset and its qualification as an investment-grade asset. Collateralized bond obligations (CBOs) are issued as a form of debt financing that transforms junk bonds into investment-grade assets.

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How Does a Collateralized Bond Obligation Work?

The issuer of a CBO is referred to as a protection buyer. For an issue of CBO, underlying collateral is required, often low-rated bonds which are otherwise called junk assets. CBOs are credit derivatives and are issued in tiers or tranches, with each tier containing a different level of risk and interest rate. For instance, it is possible to have a CBO that contains tiers or tranches namely; senior debt, mezzanine debt, and stocks. Depending on the tier each of these categories of junk bonds appears, their contribution to the portfolio varies. Junk bonds with higher levels of risk attract higher interest rates than those with low-risk levels.

Example of Use in Bond Portfolios

Generally, junk bonds have low ratings with a high level of risk. However, buyers of CBOs receive higher returns or compensations when the junk bonds have high risks, this is because, the higher the risks, the higher the interest rate paid on the bond. Junk bonds serve as the collateral in a CBO and they offer diversification of investments, risks, and returns. Collateralized bond obligations (CBOs) are issued in tiers in order to offer buyers different levels of risks and compensations.