A Collateralized Mortgage Obligation is a mortgage-backed security formed as a special purpose entity to receive mortgage payments that are deposited into a pool. Payments of principal and interest are distributed from the pool to the tranches. The mortgages provide collateral for the CMO. The tranches in the CMO are created by the risk level associated with that tranche.
Explanation of CMO
Most CMOs are structured so the tranches are paid sequentially. The highest tranche is fully paid off before the next tranche receives payments. The higher-level tranches have shorter durations than the lower levels. Z-bonds, as the lowest tranche, have the longest durations.
Mortgage securities have a risk of prepayment where the borrower will prepay a mortgage ahead of time. Prepayment risk makes future cash flows uncertain. If mortgage holders prepay their loans, they ultimately pay less interest, which results in lower cash flows into the CMO pool. Some CMOs have embedded call options that give the issuer the right to redeem the bond prior to the maturity date. The CMO investor receives a higher yield by granting the call right to the issuer.