Collateralized Bond Obligation (CBO)

A CBO works like other collateralized debt obligations: a special purpose vehicle buys a diversified portfolio of bonds, funds it with tranches of rated notes and equity, and distributes interest and principal through a priority-of-payments waterfall. The difference is the collateral. CBOs were common in the 1990s and early 2000s for high-yield corporate and emerging-market debt; today most corporate credit securitizations use loans instead, so the CBO market is far smaller than the CLO market.

Because bond collateral is generally fixed-rate and unsecured while CBO notes may be floating-rate, CBOs often embed an interest rate hedge, and recoveries on defaulted bonds tend to be lower than on senior secured loans. Coverage tests, a collateral manager and a trustee operate in the same way as in other CDOs.

How funds account for CBO holdings. Rated tranches are carried at fair value with coupon accruals; the equity tranche is valued from projected residual cash flows, usually as a Level 3 measurement. Operations teams reconcile holdings, payments and coverage-test results to monthly trustee reports.

Pitfalls. Legacy CBO positions can be illiquid, with few observable prices and limited trustee data, so valuations must be documented carefully and supported by cash flow models rather than a single broker quote. Deferred-interest tranches should be placed on non-accrual when cash interest stops, and distributions to equity should be split between income and return of capital.