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.

A synthetic CDO is a collateralized debt obligation that invests in credit default swaps or other non-cash assets to gain exposure to fixed income. Tranches are portions of secuitized financial products structured to divide risk or group characteristics in ways that are marketable to various investors.

The tranches of a CDO tell investors what level of risk they are taking on, with senior having the highest credit rating, then mezzanine, then junior. In the case of a default on the underlying loan, senior bondholders are paid from the pool of collateral assets first and junior bondholders last.

They specifically differ in that a CDO is essentially a bond backed by financial assets and a CDS is a form of insurance policy which guarantees payment to its holder in the event of default.