What Is a Collateralized Bond Obligation?

A collateralized Bond Obligation (CBO) is an investment-grade bond that is 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 from multiple issuers, they offer enough diversification to be structured as "investment grade."

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

Key Takeaways

  • A collateralized bond obligation (CBO) is a structured product that pools several junk bonds in order to create an investment grade security.
  • Pooling several securities that would be otherwise high-risk on their own creates diversification such that the pooled security is far less risky for investors.
  • Like other securitized fixed income products, CBOs are issued in tranches and are overcollaterized.

Understanding Collateralized Bond Obligations

A collateralized bond obligation (CBO) is a type of structured debt security that 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 that are separated into tiers called tranches. Each tier represents a certain level of risk that determines the interest that will be 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.

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.

Securitization of Pooled Bonds

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 a 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, which means these are backed by collateral that is worth more than enough to cover potential losses in cases of default. 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.