CDO Tranche

 

 

A Collateralized Debt Obligation (CDO) is an investment created by integrating a pool of similar credit instruments into a single portfolio. A CDO investor is only entitled to a specific percentage of this pool’s principal and interest income, depending on the CDO tranche on which the funds are invested. A CDO tranche is a sub-division of the collateralized debt obligation asset pool, each having a different principal, interest, maturity and default risk.[br]

 

Structure of CDO Tranche

Typically, a collateralized debt obligation pool is divided into three tranches; wherein each tranche behaves as a separate CDO, enabling the CDO originators to attract multiple investors having varying risk preferences.

• Senior Tranche or Senior Debt: This is typically highly rated, since it is ranked on top in terms of priority of payments. However, the interest rate on investments in this tranche is the lowest due to the lower risk that accompanies them.

• Mezzanine Tranche: This tranche has moderate returns and moderate risk.

• Equity Tranche: Investment in this tranche yields the highest interest rate. This high rate is offered to counter the higher risk on this tranche. Equity tranche investors are the first to lose funds when loans in the pool are not repaid.  

CDO Tranche and Correlation to Risk

The pricing of a CDO tranche reflects an investor’s expectation of the correlation of defaults on the reference portfolio. This correlation effect is stronger in single-tranche CDOs than in standard CDOs. A single-tranche CDO is a more flexible portfolio than a regular CDO. In case of a standard CDO, underwriters can only close the sale of an asset pool when all the tranches are sold to different investors. However, with single-tranche CDOs, investors can close the deal on different tranches independently.[br]

 

The effect of default correlation on the standard CDO tranches is intuitive. A higher default correlation implies a greater possibility of elimination of the equity and mezzanine tranches. These, in turn, are anticipated to inflict loss on the senior tranche. Consequently, as the correlation increases the value of the senior tranche declines.

 

Conversely, increasing default correlation increases the value in the equity tranche. This is because when the correlation peaks, it is anticipated to come down. Finally, mezzanine tranches are affected by both the situations, which cancel each other out to make the mezzanine tranche less sensitive to correlation.