While the underlying assets of regular CDOs are traditional fixed-income assets, such as loans, mortgages, and bonds, synthetic CDOs use non-cash assets as the underlying asset, such as credit default swaps, options, and other such contracts. Synthetic CDOs typically offer higher yields than traditional CDOs.

Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS. CDOs are viewed as complex and opaque financial instruments.

A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period.

key Takeaways CDOs are divided and sold to investors in tranches, reflecting their degree of risk. A CDO may in fact include mortgage-backed securities in its holdings.