Collateralized Bond Obligation - CBO

It’s always comforting when a bond you buy is backed up by some sort of collateral. But what if the collateral is a pool of junk bonds? Would you feel better if they were high-yield junk bonds?

A collateralized bond obligation (CBO) is a type of bond for the adventurous that uses a variety of high-yield junk bonds as collateral. Collateral is something that is put up as a guarantee in case the issuer of the bond defaults, just like you would use your house as collateral for a home equity loan. The good news is that these high-yield bonds generally pay a higher interest yield. The other benefit is that this pool of junk bonds is chosen to provide a variety of risk levels, so they offer enough diversity to be considered investment grade (vs. junk status).

Since there is a mixture of high-grade and low-risk bonds, most likely all of them will not default, making the CBO a lower risk investment. CBOs are also considered to be “overcollateralized” (having more collateral than they need, just in case) so the bond issuer can sell them with a high rating from the credit rating agencies. If some of the junk bonds default, there will be extra collateral to cover the interest payments. Feel better now?