Definition of Collateralized Bond (or Debt) Obligation (CBO or CDO)

investment grade bond backed by a pool of variously rated bonds, including junk bonds. CBOs are similar in concept to Collateralized Mortgage Obligations (CMOs), but differ in that CBOs represent different degrees of credit quality rather than different maturities. Underwriters of CBOs package a large and diversified pool of bonds, including high-risk, high-yield junk bonds, which is then separated into "tiers." Typically, a top tier represents the higher quality collateral and pays the lowest interest rate; a middle tier is backed by riskier bonds and pays a higher rate; the bottom tier represents the lowest credit quality and, instead of receiving a fixed interest rate, receives the residual interest payments-money that is left over after the higher tiers have been paid. CBOs, like CMOs, are substantially overcollateralized and this, plus the diversification of the pool backing them, earns them investment-grade bond ratings. Holders of third-tier CBOs stand to earn high yields or less money depending on the rate of defaults in the collateral pool. CBOs provide a way for big holders of junk bonds to reduce their portfolios and for securities firms to tap a new source of buyers in the disenchanted junk bond market of the early 1990s.