8 Types of Controversial Debt Securities
A debt security is a financial instrument that's issued by a company or institution and sold to an investor with an agreement to pay back the face value and interest until it reaches an agreed upon maturity date or renewal date. Common types of debt securities include government bonds, corporate bonds, and municipal bonds.
Traditionally, investors have bought debt securities because of the lower risk associated with them. However, in more recent years, a newer class of riskier, more controversial debt securities have come about. These include catastrophe bonds, collateralized debt obligations, collateralized loan obligations, mortgage-backed securities, collateralized mortgage obligations, covered bonds, death bonds, and junk bonds. Many finance experts point to these types of debt securities as some of the main contributors to the 2008 financial crisis.
Unlike more traditional debt securities, individual investors do not usually buy these more controversial types of debt securities. Institutional investors, such as hedge funds and pension funds, are usually the main purchasers.
Catastrophe bonds, also known as cat bonds, act like debt securities until catastrophic events, such as earthquakes and storms, happen. Then, they essentially morph into casualty insurance policies that, in effect, pay the issuer.
Collateralized debt obligations, or CDOs, are a type of debt security that is backed by other debt instruments. Bonds built upon bonds, if you will. A CDO is created when a financial institution pools borrower debt together, divides it up based on risk, then sells those divided pools of debt, called tranches, to investors.
Collateralized Loan Obligations
A collateralized loan obligation, or CLO, is a variation on the concept of the CDO. However, the underlying assets are corporate loans that have low credit ratings instead of publicly traded bonds. Similar to a CDO, a financial institution pools loan debt together to create a CLO, divides it up based on risk, and sells those groups of debt, or tranches.
Mortgage Backed Securities
A mortgage-backed security, or MBS, is a debt security backed by home mortgages—usually a bundle of several mortgages that have similar interest rates or other similar characteristics. Investors usually receive monthly payments that include interest and principal.
Collateralized Mortgage Obligations
A collateralized mortgage obligation, or CMO, is a type of mortgage-backed security. It's similar to a CLO, except that it's built upon pools of mortgages and not other loans. It's also known as a real estate mortgage investment conduit (REMIC).
Covered Bonds have been common in Europe for a while, but they're still gaining popularity in the United States. Though they have some superficial resemblance to a CMO, they have a crucial difference that dramatically reduces the risk to the holder: They're backed by a separate group of assets, so the investor won't lose all of their money if a financial institutionthat issues the bond becomes insolvent.
Death bonds are made up of transferable life insurance policies that are bundled together and sold to investors. The way that this happens is a company buys a person's life insurance policy for a one-time cash payment. That company, usually known as a life settlement company, resells the policy to an investment bank, which groups several policies together to sell as bonds.
Junk Bonds are similar to regular bonds, except that the issuer has a low credit rating. Because of this, they have the potential to pay higher yields than regular bonds to investors, but they also come with higher risks.