Are Collateralized Debt Obligations Risky Investments?

A collateralized debt obligation (CDO) is a security backed by a pool of assets, such as mortgages, credit card debt, or other types of loans. The issuer of a CDO assembles different types of debt instruments and sells ownership stakes in the CDO to investors. Because the underlying assets are diverse, CDOs offer investors exposure to a wide range of risks. For this reason, some market observers believe that CDOs are risky investments. Others contend that for conservative investors, properly structured CDOs can be an attractive way to gain diversified exposure to the debt market.

Collateralized debt obligations are a collection of secured debts, which is where the “collateral” part comes in. With secured debts, borrowers are required to put up an asset as collateral. If they default, that asset can be seized.

They are typically taken on by institutional investors like pension funds, insurance companies, banks, investment managers and other financial institutions.

Different types of CDOs may be known by different names, based on the type of loans packaged in the CDO. For example, a CDO of mortgage loans is known as a “mortgage-backed security” (MBS), while other collections of debt like credit cards, student loans and corporate debt are known as “asset-backed securities.”

The advantage of CDOs is that, when the economy is strong, these high-risk investments can turn out better returns compared to other fixed-income products in their portfolio. For institutional investors like pension funds, insurance companies and hedge funds, that translates into higher profits.

Since CDOs aren’t tangible assets, their value is determined through a computer model. As those have become more complex, so has evaluating risk. Read more

What are your thoughts on collateralized debt obligations? Are they risky investments? Let us know in the comments below!

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