Collateralized debt obligation (CDO)
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Definition
A structured security issued by a special-purpose vehicle that owns a pool of debt instruments (corporate bonds, loans, ABS, MBS) and pays investors via a waterfall through senior (AAA), mezzanine (BBB), and equity (unrated, first-loss) tranches. Credit enhancement via overcollateralization and excess spread absorbs early defaults before they reach rated tranches.
Collateralized debt obligation (CDO) in plain English
A CDO bundles hundreds of loans and bonds into one big pool, then sells slices of that pool to different investors. The clever part is that the slices aren't equal: cash flowing in from the loans fills the "safe" slices first (rated AAA, seen as very unlikely to lose money), then the middle slices, and only what's left trickles to the bottom "equity" slice, which is also the first to eat any losses when borrowers don't pay. That ranked payout order is called a waterfall, and extra cushions, like stuffing in more loans than strictly needed (overcollateralization), let early defaults get absorbed before they ever reach the top slices. Picture a tiered fountain: water fills the top bowl first and spills downward, so in a drought the bottom bowl runs dry first.
Also called: CDO
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