According to Forbes, collateralized debt obligations are “investment-grade security backed by a pool of various other securities that can be made up of any type of debt, in the form of bonds or loans”. This process of “pooling in debt to reduce risk and raise returns” is known as collateralized debt obligation. The process of splitting the debt into different tranches to assign the payment priority and interest rate is known as securitization.

Investment banks can buy mortgages and assign them to certain entities. They can now sell shares of these mortgages at a certain share price and yield rate. There will always be different investors; there are those who are risk averse and find the shares to be too risky, and those who can afford the higher risk and find the yield to be too low. To accommodate both ends, these shares are sliced into different classes also known as tranches.

Since mortgage backed securities all paid the same amount, the class will determine who gets paid first. The higher-rated tranche will have a lower interest rate for lower risk, and the lowest-rated tranche which may even be a junk rating will have a higher interest rate but at the cost of high risk because they may not get paid.

It is widely believed that these financial instruments played a big role in the 2008 financial crisis. One problem about collateralized debt obligations is that sometimes they are very complex made up of so many things that nobody really understands what they are and what they’re investing in. However, since it helps financial institutions generate money, they will continue to sell them.