A collateralized debt obligation is an investment product backed by a pool of underlying assets. Those assets serve as the pledged collateral in case of a default. The CDO is created by an investment bank that gathers together cash flow generating assets such as mortgages, bonds, and other loans.
CDO issuances are usually broken up into senior, middle, and junior tranches. Each tranche is backed by a different set of assets, with the senior tranche backed by the highest credit-rated assets, and so on. Should the bonds go into default, the underlying assets are sold off, producing capital to repay investors.
CDO investors are most often institutional investors such as hedge funds and pension funds.
Example:
Suppose a Housing Authority wants to issue housing bonds but they have a poor credit rating. They can issue CDOs backed by a portfolio of previously issued loans.
The Housing Authority is responsible for paying the principal and interest on the bonds. If they are unable to pay the debt service and the bonds go into default, the underlying collateralized loans are sold and the proceeds are used to repay investors.
The collateral pledge that secures the CDO ensures that in the case of a default, investors are more likely to be repaid. The different tranches indicate which investors have the first claim to the collateral.
Senior debt is generally considered the lowest risk and has the first claim to collateral, but also offers a lower yield. Junior debt is considered higher-risk and only recover their losses after the senior tranches. But to compensate for this increased risk, junior debt also offers higher yields to investors.