Through securitization, issuers can repackage several assets into one and offer them to investors. One common type of these securities possible through securitization is asset-backed securities. Likewise, asset-backed Securities (ABS) have several other types of securities. Collateralized debt obligations are one of the types of these ABS.
What is a Collateralized Debt Obligation?
A collateralized debt obligation (CDO) is a type of asset-backed security that groups together several kinds of loans and other assets. Once issuers pool these assets and loans, they sell them to institutional investors. A CDO is a form of derivative as it derives its value from another underlying asset. In case the borrower defaults on the loan, the underlying asset acts as the security.
Another name for collateralized debt obligation is collateral loan obligation. With these securities, issuers can package various loans together, and sell them to investors on the secondary market. There are several types of assets or loans that may be a part of collateral debt obligations. These include auto loans, mortgages, corporate debt, credit card debt, etc.
These securities get their name from the underlying promised repayments acting as collateral. These repayments also give the CDOs their values. A CDO-holder has the right to collect these repayments at the end of the loan period.
How does Collateralized Debt Obligation work?
Collateralized debt obligations are a type of asset-backed securities. Usually, collateralized debt obligations are prevalent with commercial papers as well, when the underlying assets consist of corporate debt. Usually, CDOs come from the bank. These institutions may issue CODs to get funds to facilitate more loans. By converting their existing loans into CDOs, they can use investors to finance their loan facilities.
Similarly, financial institutions use CDOs to mitigate their risk. By securitizing their existing debt, banks can transfer the risks associated with them to investors. Likewise, it lets them convert these into assets on their Balance Sheets. CDOs also allow banks to come up with new and more profitable products to sell. With CDOs, banks are essentially selling their debt and the associated risks to another party.
In the past, the underlying assets in collateralized debt obligations majorly consisted of corporate bonds, sovereign bonds, and bank loans. However, the range of the underlying assets that come with these securities has significantly increased. A CDO repackages various debt instruments and gathers income from them. This income then goes to a prioritized set of CDO securities.
What are the advantages of Collateral Debt Obligations?
CDOs can be beneficial for both financial institutions and investors. For banks, the advantages are as stated above. It allows these financial institutions to generate more funds and finance their activities. Similarly, they can use it to transfer their risks.
Investors, on the other hand, can match CDOs to their required risk tolerance level. There are various types of CDOs that come with variable risks. Investors can choose between these and select the one that suits their needs. As with other investments, high-risk CDOs come with higher returns while those with lower risks bear lower returns.
Conclusion
Collateralized debt obligations are a type of asset-backed securities. Issuers pool various loans together and sell them to investors through these obligations. CDOs can be beneficial for banks or issuers for several reasons, such as raising finance and transferring risk. In addition to that, they can also provide investors with variable risk and return investments.
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