Mortgage bonds and CLOs
By SuperdayReps · Michigan Ross Undergrad | Wharton MBA · ex-Citi | ex-Greenhill · Former Head Mentor at a Leading IB Prep Service
15 min read · updated November 3, 2026
Mortgage bonds are one of the largest bond markets in the world after government debt, and CLOs are the biggest buyers of the loans that fund leveraged buyouts. A securitized products desk trades both, and its traders spend their days on two questions: how fast will these borrowers pay me back, and how much loss can sit under my tranche before it reaches me?
Interviewers ask about these products for two reasons. The mechanics test whether you can reason about options you cannot see (a homeowner's right to refinance) and about who gets paid first. And 2008 is a near-certain follow-up, so you need to explain what went wrong in plain terms and why a CLO is not the same thing.
Securitization pools loans and slices the cash into tranches paid in order, so senior tranches can be far safer than the loans themselves. What sits in the pool decides the risk. For agency mortgage bonds, credit is guaranteed and the risk is prepayment, which makes them negatively convex. For CLOs, the risk is corporate default, and it is managed by subordination and by coverage tests that redirect cash to the senior notes when the pool weakens.
Securitization in one example
Securitization turns loans sitting on a lender's balance sheet into bonds. The lender sells a pool of loans to a special purpose vehicle, a separate legal entity set up only to hold them, and the vehicle issues bonds paid from the loans' cash flows. The lender gets cash back to lend again.
Two ideas do the work:
- Pooling. One borrower defaulting barely matters among thousands.
- Tranching. The bonds are split into tranches paid in a set order. Senior tranches are paid first and lose last. Junior tranches are the reverse.
Take a pool of $100 million of loans funded by an $80 million senior tranche, a $15 million mezzanine (middle) tranche and $5 million of equity at the bottom.
| Loan losses | Equity loses | Mezzanine loses | Senior loses |
|---|---|---|---|
| $4 million | $4 million (80% of it) | nothing | nothing |
| $12 million | $5 million (all of it) | $7 million | nothing |
| $25 million | $5 million | $15 million (all of it) | $5 million |
The senior tranche has $20 million of junior money beneath it that absorbs losses first. That is how a AAA tranche can be built from loans that are not AAA.
| Product | What is in the pool | Main risk to the investor |
|---|---|---|
| Agency MBS | Home mortgages guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae | Prepayment |
| Non-agency MBS | Home mortgages with no guarantee | Prepayment and credit |
| CMBS | Commercial property mortgages | Credit, tied to the buildings |
| ABS | Auto loans, credit cards, student loans, equipment leases | Credit of many small borrowers |
| CLO | Leveraged loans to companies, actively managed | Corporate default |
| CDO | Other debt, often tranches of other securitizations | Correlated credit losses |
Strictly, a CLO is a kind of CDO whose pool is corporate loans, but in practice the names describe different markets.
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Frequently asked
- What is securitization?
- Pooling many loans into a separate legal entity and selling bonds paid from the loans' cash flows. The lender gets its money back to lend again, and investors get bonds that are split into tranches paid in order, senior first. What separates MBS, ABS and CLOs is what sits in the pool: mortgages, consumer receivables or leveraged loans.
- Why do mortgage-backed securities have negative convexity?
- Homeowners can repay their mortgages early, and they do so most when rates fall and they can refinance. So when rates drop, the bond shortens and its price rises less than a normal bond's. When rates rise, prepayments slow, the bond lengthens and its price falls more. Gains are capped and losses are extended.
- Are agency MBS risky?
- Not much for credit. Fannie Mae, Freddie Mac and Ginnie Mae guarantee the principal and interest, so a homeowner's default reaches the investor as an early repayment at par, not a loss. The main risk is prepayment: getting money back early when rates are low and late when rates are high.
- What protects the senior notes in a CLO?
- Two things. The junior tranches and equity underneath take losses first. And coverage tests: if the loans' par value or interest falls too far relative to the notes, cash that would have gone to the junior tranches and equity is used to pay down the senior notes until the tests pass again.
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