DEFINITION of 'Collateralized Bond Obligation - CBO'

Collateralized Bond Obligation (CBO) is an investment-grade bond backed by a pool of junk bonds. Junk bonds are typically not investment grade, but because the pool includes several types of credit quality bonds together, they offer enough diversification to be "investment grade."

BREAKING DOWN 'Collateralized Bond Obligation - CBO'

A collateralized bond obligation (CBO) is a type of structured debt security which has investment-grade bonds as the underlying assets backed by the receivables on high-yield or junk bonds. The structured debt instrument is securitized by packaging a large number of bonds with varying degrees of credit quality. The bonds are a mix of low-risk and high-grade bonds which are separated into tiers. Each tier represents a certain level of risk that determines the interest that will paid to investors. The top tier of a CBO contains bonds that are deemed to be high quality and low risk and, thus, pays low interest rate; the middle tier is backed by higher risk bonds and pays higher interest than the top tier; the bottom tier of the debt security represents bonds with the lowest quality and receives any interest payment left over after the higher tiers have been paid. Because of the high risk of investing in the bottom tier, CBO holders receive a high yield on this level.

The securitization of bonds into CBOs can be said to be a mechanism that converts junk bonds into investment grade securities. Since it is unlikely that all of the junk bonds will default, returns on CBOs have lower risk than the individual bonds backing them. CBOs are, therefore, rated investment grade. This attractive rating is also applied to CBOs due to the fact that the security is overcollateralized. Overcollateralization makes it possible for issuers to sell securities with a high rating attached because excess collateral is used to enhance credit in order to get a better debt rating from a credit rating agency. An issuer backs a bond with assets or collateral which has value in excess of the loan, thereby, limiting credit risk for the creditor and enhancing the credit rating assigned to the loan. So, even if some of the payments from the underlying bonds default or are late, principal and interest payments on a collateralized bond obligation can still be made from the excess collateral.

CBOs offer fixed-income investors the opportunity to benefit from the high-yield potential of junk bonds with a lower degree of risk. It also provides a way for big holders of junk bonds to reduce their portfolios by packaging and selling their receivables on bonds to investors in order to reduce the risk coming from defaults.

Collateralized bond obligations are similar in structure to a collateralized mortgage obligation (CMO), but different in that CBOs represent different levels of credit risk, not different maturities.

  1. Collateral Trust Bond

    A collateral trust bond is a bond that is secured by a financial ...
  2. High-Yield Bond

    A high-yield bond pays a higher yield due to having higher risk ...
  3. Corporate Bond

    A corporate bond is a debt security issued by a corporation and ...
  4. Bond

    A bond is a fixed income investment in which an investor loans ...
  5. Obligation Bond

    A municipal bond whose face value of the bond is greater than ...
  6. Dollar Bond

    A dollar bond is a U.S. denominated bond that trades outside ...
Related Articles
  1. Investing

    Everything You Need to Know About Junk Bonds

    Despite their name, junk bonds can be valuable investments for informed investors, but their potential high returns come with the potential for high risk.
  2. Investing

    High Yield Bond Investing 101

    Taking on high-yield bond investments requires a thorough investigation. Here are looking the fundamentals.
  3. Financial Advisor

    The U.S. High-Yield Bond Market: A Brief History

    The U.S. high-yield corporate bond market has existed for decades; it's known for its rapid growth periods as well as for its risks.
  4. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  5. Financial Advisor

    Junk Bonds: Why You Should Pass Right Now

    Why you should probably wait on allocating to junk bonds right now.
  6. Investing

    9 Junk Bond ETFs You Should Eye Right Now (HYG, JNK)

    Volatility aside, there’s still some value left in high yield bonds. Pending rate increases shouldn’t effect junk as gravely as investors fear.
  7. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  8. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  9. Investing

    The History of High-Yield Bond Meltdowns

    The high-yield bond market experienced its major growth streak in the 1970s and 1980s and has had several noteworthy meltdowns between then and now.
  1. Are high-yield bonds better investments than low-yield bonds?

    It depends on the amount of default risk you as an investor want to be exposed to. More yield goes hand-in-hand with more ... Read Answer >>
Trading Center