Collateralized Bond Obligation (CBO)
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 regularly not investment grade, but since the pool incorporates several types of credit quality bonds together from various issuers, they offer sufficient diversification to be structured as "investment grade."
Collateralized bond obligations are comparable in structure to a collateralized mortgage obligation (CMO), however divergent in that CBOs address various levels of credit risk from bond issuers, not from a pool of mortgages.
Figuring out 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 bundling a large number of bonds with shifting degrees of credit quality.
The bonds are a mix of low-risk and high-grade bonds that are separated into tiers called tranches. Every tier addresses a certain level of risk that decides the interest that will be paid to investors. The top tier of a CBO contains bonds that are considered to be high quality and low risk and, in this manner, pays low-interest rate; the middle tier is backed by higher risk bonds and pays higher interest than the top tier; the base tier of the debt security addresses bonds with the lowest quality and receives any interest payment left over after the higher tiers have been paid. In light of the high risk of investing in the base tier, CBO holders receive a high yield on this level.
CBOs offer fixed-income investors the opportunity to benefit from the high-yield capability of junk bonds with a lower degree of risk. It likewise gives a way to big holders of junk bonds to reduce their portfolios by bundling and selling their receivables on bonds to investors to reduce the risk coming from defaults.
Securitization of Pooled Bonds
The securitization of bonds into CBOs can be supposed to be a mechanism that converts junk bonds into investment-grade securities. Since it is improbable that all of the junk bonds will default, returns on CBOs have a lower risk than the individual bonds backing them. CBOs are, in this manner, rated investment grade. This appealing rating is additionally applied to CBOs due to the way that the security is overcollateralized, and that means these are backed by collateral that is worth all that could possibly be needed to cover likely losses in instances of default. Overcollateralization makes it workable for issuers to sell securities with a high rating connected in light of the fact that excess collateral is utilized to improve credit 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, in this manner, restricting credit risk for the creditor and upgrading the credit rating assigned to the loan. Thus, even on the off chance that a portion of the payments from the underlying bonds default or are late, principal and interest payments on a collateralized bond obligation can in any case be produced using the excess collateral.
Highlights
- Pooling several securities that would be generally high-risk all alone makes diversification to such an extent that the pooled security is undeniably safer for investors.
- Like other securitized fixed income products, CBOs are issued in tranches and are overcollaterized.
- A collateralized bond obligation (CBO) is a structured product that pools several junk bonds to make an investment grade security.
