A collateralized mortgage obligation or CMO is a fixed-income investment backed by mortgages or pools of mortgages. Collateralized mortgage bonds are also used in hedge funds, pensions, and mutual funds.
CMOs differ from traditional mortgage-backed securities because they do not offer a single interest or maturity date. Instead, they offer different interest and maturity rates for each tranche or class.
In general, CMOs are divided into three tranches. Each tranche receives regular installment payments for the principal they doled out, plus interest, with the first tranche having the earliest maturity date and highest interest. In return for the best potential yield, investors of the first tranche shoulder the highest risk for the investment, since they absorb the greatest loss in case mortgages are not paid off.
CMOs can also have a fourth tranche. This fourth tranche is not paid in installments, but in full upon maturity, which is usually only when the full face value of the mortgages are paid up. The interest in this tranche is accrued until maturity. The advantage of this tranche is that is usually contains deep-discount zero coupon bonds, making it one of the most affordable investments. Due to the affordability, even with its low yield and long maturity, it is still attractive for investors who can sit on the investment for a time.
CMOs are usually made up of high-quality mortgages, which significantly lessen the risk. However, this means that the potential yield is also reduced when compared to traditional mortgage-backed investments.