What distinguishes various classes of securities in a Collateralized Debt Obligation (CDO)?

In a Collateralized Debt Obligation (CDO), different classes of securities, commonly referred to as tranches, are characterized by their varying levels of risk and return. Each tranche has distinct priority in the cash flow waterfall of the underlying assets, which means they are paid in a specific order during the distribution of income from the collateral. The senior tranches are typically paid first and carry lower risk and lower yields, while subordinate tranches are paid later, assuming more risk and, as a result, offering higher potential returns.

This distinction among tranches is fundamental to the structure of a CDO, as it allows investors to choose securities that align with their risk tolerance and investment goals. The tranche system facilitates the segmentation of risk and helps in meeting the requirements of various types of investors, each looking for different exposures in the capital structure.

The other factors—such as the initial investment amount, the credit rating of the issuing firm, and the maturity date—do not inherently delineate the risk and return profile of each class of securities within a CDO to the same degree. While they may influence the overall attractiveness of the investment, they are not defining characteristics of what differentiates the securities within the structure of a CDO. The tranche itself is