Quick Answer
A CDO tranches a pool of diverse debt (corporate bonds, loans, MBS, ABS) into senior, mezzanine, and equity classes by priority of claim. The equity tranche absorbs losses first and carries the highest risk and yield; the senior tranche is paid first and carries the lowest. Unlike a CMO, which redistributes prepayment risk within a mortgage-only pool, a CDO redistributes credit risk across varied collateral.
The collateral type and the risk being redistributed are the two facts the exam uses to tell a CDO apart from a CMO.
What Is the Structure of a CDO?
- CDOs are structured securities backed by a pool of diverse debt instruments: corporate bonds, loans, Mortgage-Backed Securities (MBS), Asset-Backed Securities (ABS), and other debt securities
- Unlike CMOs (mortgage-only collateral), CDOs are backed by a broader range of debt
- CDOs are divided into tranches with different risk levels and priorities of claim
CDO Tranche Hierarchy
| Tranche | Priority | Risk | Yield | Typical Rating |
|---|---|---|---|---|
| Senior | Highest (paid first) | Lowest | Lowest | Typically AAA |
| Mezzanine | Middle | Moderate | Moderate | BBB to A range |
| Equity (Junior) | Last (first to absorb losses) | Highest | Highest potential | Often unrated |
Think of it this way: Losses flow upward through a CDO like water filling floors in a building. The equity tranche is the ground floor and floods first. The mezzanine is the middle floor. The senior tranche is the top floor and only gets wet if the entire building is underwater.
When defaults occur in the collateral pool:
- Equity tranche investors bear losses first
- Then mezzanine tranche absorbs losses
- Then senior tranche (last to take losses, most protected)
Exam Tip: Gotchas
- The equity tranche is the RISKIEST despite its name suggesting ownership. It absorbs losses first and often carries no credit rating at all.
- Higher risk tranches are compensated with higher yields. Equity tranche investors accept greater loss exposure in exchange for higher potential returns.
How Does a CDO Compare to a CMO?
| Feature | CMO | CDO |
|---|---|---|
| Collateral | Mortgage loans or MBS only | Diverse debt (corporate bonds, loans, MBS, ABS) |
| Primary risk redistributed | Prepayment risk (among tranches) | Credit/default risk (among tranches) |
| Tranche types | planned amortization class (PAC), targeted amortization class (TAC), companion, Z, sequential | Senior, mezzanine, equity |
| Loss absorption | Companion tranches absorb prepayment variability | Equity tranche absorbs credit losses first |
Key distinction: CMOs deal primarily with timing risk (when principal is returned), while CDOs deal primarily with credit risk (whether principal is returned at all).
Exam Tip: Gotchas
- CMO tranches redistribute prepayment risk; CDO tranches redistribute credit/default risk. The type of risk is the key differentiator on the exam.
- CDOs can contain MBS as part of their collateral pool, blurring the line. The key is that CDOs are NOT limited to mortgages.
What Should You Check on Exam Day?
- Order CDO loss absorption correctly: equity first, then mezzanine, then senior last.
- Distinguish a CDO's credit/default-risk redistribution from a CMO's prepayment-risk redistribution before choosing an answer.
- Do not assume "equity tranche" means ownership or safety; it is the riskiest, often unrated slice.
- Confirm the collateral pool is diverse debt, not mortgage-only, before labeling a structured product a CDO rather than a CMO.