What Is a Collateralized Debt Obligation?

By Kristi Waterworth – Updated Feb 25, 2025 at 11:46 PM

Key Points

CDOs mix various debt types, balancing risk and reward, suitable for risk-ready investors.
Synthetic CDOs invest in derivatives like credit swaps, presenting higher risks and returns.
Study CDO structure; blend high-rated senior and riskier junior debts for optimal returns.

Considering other types of investments beyond stocks and bonds? Collateralized debt obligations can provide a solid return for investors willing to take on some risk.

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A scale weighing risk and reward. — Image source: Getty Images.

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Asset

An asset is a resource used to hold or create economic value.

Some CDO components are riskier but offer higher returns; some are much safer but with lower returns. Banks often use them to help offload debt and increase available cash reserves.

A synthetic CDO is another type of CDO, this one much riskier. Instead of investing in consumer debt, they invest in contracts, like credit default swaps and options, making them considerably more likely to fail. Interest rates are also much higher with synthetic CDOs than with regular ones -- so with great risk can come great reward.

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When you're looking at a collateralized debt obligation as an investment, you'll see it's structured in a very specific way. These are essentially a collection of debt vehicles, each described by their seniority, maturity date, and Standard and Poor's (S&P) credit rating.

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Those with senior debt positions and high S&P credit ratings are the least risky and most likely to produce returns. Similarly, junior debt positions with the lowest credit ratings are the riskiest. These are technically collateralized assets, but like any collateralized debt, it's common for there to be insufficient enough equity for the lowest positions to be paid in full if they were to default.

When looking at the mix in the CDO you're considering, always balance risk with reward. That generally means choosing a mix of highly rated senior debt and a much smaller percentage of lower-rated junior debt that will pay handsomely as the debt is satisfied.

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Exchange-Traded Fund (ETF)

An exchange-traded fund, or ETF, allows investors to buy many stocks or bonds at once.

In addition, each CDO is diversified, which is good for someone looking for some riskier exposure to a collection of investments outside of assets like exchange-traded funds (ETFs). Each CDO comprises several different loans and, ideally, loan types. So you may have a CDO with mortgages, car loans, and bonds wrapped together, reducing the overall risk of the instrument.

Generally, the coupon rate of these various debt instruments within a CDO is based on the interest rate the borrower is paying. So newly minted CDOs may be a lot more appealing than just two years ago.

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As it became clear that wasn't possible because home values were dropping instead of rising, people walked away from their homes, defaulting in huge numbers. The defaults drove down housing prices even further, and the financial institutions holding many of these CDOs hemorrhaged money, unable to sell the repossessed properties for anywhere near enough to satisfy the debts associated with them.

CDOs have changed significantly. But because there is still very little regulation surrounding them, it's very important to fully understand what you're getting into when investing in these instruments.

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About the Author

Kristi Waterworth has been a contributing real estate and financial expert at The Motley Fool, covering real estate, investing, and personal finance topics, since 2020. Kristi has been interviewed by various TV media outlets and podcasts for her real estate investing expertise – from residential real estate to digital real estate and everything in between. Kristi’s journalist career spans over 25 years, and she has written about real estate investing, homeownership, and home construction specifically for the last decade. She was also previously a licensed Realtor and general building contractor before the Great Recession and housing market collapse. She holds a bachelor’s degree in American history from Columbia College in Missouri.

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