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Collateralized Bond Obligations

A collateralized bond obligation (CBO) is an investment-grade bond backed with by a pool of high-yield junk bonds, which are not considered to be of investment-grade on a standalone basis. The junk bonds in a CBO are from different classes and purposely chosen to be diversified. CBOs offer fixed-income investors the opportunity of enjoying the high-yields that junk bonds offer coupled with a lower level of risk through diversification.

A CBO is typically issued at two or more levels (called tiers or tranches) with various degrees of risk and interest rates. The senior-most tranche of a CBO is the safest as the interest and principal payments are made in order of seniority. Seniority refers to the order of repayments; senior debt is repaid first before junior debt is repaid. Because of the extra risk compared to senior tranches, junior tranches are compensated with a higher yield.