CDOs look to make above average returns by making leveraged investments in a portfolio of high yield bonds or leveraged loans. It is primarily funded with debt (multiple tranches in a waterfall structure, where each tranche has different risk and credit ratings).

Securitization teams in investment banks will be responsible for this division. This becomes an example in pure math and each tranche gets a funding cost in line with what to expect for the credit rating. All gains beyond the lowest rated tranche is returned to equity.

The collateral is the underlying debt – as you can see the loans or bonds purchased by the CDO are overcollateralized so that there is a security cushion for the various tranches, hence the lower risk.