Definition of collateralised debt obligation

A collateralised debt obligation, CDO, is effectively a tradeable bond whose income payments and principal repayments are dependent on a pool of different financial instruments. Collateralised debt obligations differ from asset backed securities (ABS) which are backed by a homogenous pool of instruments such as only mortgages or only credit card loans. In the case of CDOs mortgages could be packaged with other loans or instruments. The different financial instruments are gathered together into a special purpose entity or special purpose vehicle and divided into tranches. Senior tranches pay the lowest interest rates but are the safest investment because should there be any default, seniors are paid first. There are also more junior tranches which might be called mezzanine or equity. Equity tranches would attract the highest interest rates but suffer the highest risk of default. CDOs are therefore promises to pay both interest and principal to investors in a prescribed sequence.