Both collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are similar in that investors receive payments from a pool of underlying assets. The difference between these securities lies in the type of assets that provide cash flow to investors.
What Is a Collateralized Mortgage Obligation?
A CMO is a type of mortgage-backed security (MBS) with separate pools of pass-through security mortgages that contain varying classes of holders and maturities (tranches). When the mortgages underlying a CMO are of poor credit quality, such as subprime loans, over-collateralization will occur.
In over-collateralization, the issuer will post more collateral than is necessary in an attempt to obtain a better debt rating from a credit rating agency. A better rating is often assigned because investors are cushioned (to some extent) from a certain level of default on mortgages within the pool. The principal repayments from the mortgages are paid to investors at various rates, depending on which tranche the investor buys into.
(For more on this, see Profit From Mortgage Debt With MBS.)
What Is a Collateralized Bond Obligation?
On the other hand, a CBO is an investment-grade bond backed by a pool of low-grade debt securities, such as junk bonds, rather than mortgages. CBOs are separated into tranches based on various levels of credit risk, rather than different maturities.
Like CMOs, CBOs are also able to increase their credit ratings. However, their credit rating is increased to investment grade through the diversification of various bond qualities, rather than through over-collateralization.