An asset-backed security (ABS) is a security created by pooling non-mortgage assets that is then resold to investors. A collateralized debt obligation (CDO) is a complex type of ABS that can be based on non-mortgage assets, mortgage assets or both together.

Understanding the Differences

The ABS evolved from mortgage-based securities (MBS], which are created from pools of mortgage assets, typically first mortgages on homes. Rather than mortgages, ABSs are backed by credit card receivables, home equity loans, student loans, auto loans and other non-mortgage financial vehicles.

A CDO is an ABS issued by a special purpose vehicle (SPV), which is a business entity or trust formed specifically to issue the CDO. CDOs are sometimes classified by their underlying debt. Collateralized loan obligations (CLOs) are CDOs based on bank loans, for example. Collateralized bond obligations (CBOs) are based on bonds or other CDOs.

In structured finance-backed CDOs, the underlying assets are ABS, residential or commercial MBS, or real estate investment trust (REIT) debt. Cash CDOs are backed by cash-market debt instruments, while synthetic CDOs are backed by other credit derivatives.

In contrast, a collateralized mortgage obligation (CMO) is a complex type of MBS. Unlike a CDO, a CMO is based on MBS only, so it can be hit particularly hard by interest rate changes, prepayments and mortgage credit risks. CDOs and CMOs are both targeted at institutional investors. In a CMO, interest rate and principal payments may be broken down into various classes of securities, depending on the riskiness of the mortgages, but this is not required.

In the CDO, however, instruments with various amounts of credit quality and return are grouped into at least three tranches, each with the same maturity level. The equity tranches pay the highest yield but carry the lowest credit ratings. The senior tranches provide the best credit quality but the lowest yield. The mezzanine tranches fall somewhere between the equity and senior tranches in terms of credit quality and yield.