Hi Claire
Yes, I think so - but happy to be corrected by others if I am wrong! I also struggled with that question initially and the below are the results of my research.
An investor in a CDO purchases investments in a particular 'tranche', eg:
- a senior tranche (say AAA rated)
- a mezzanine tranche (say BB rated)
- an equity tranche (unrated, residual tranche).
Say that the underlying assets for the CDO are mortgages.
At a basic level, the returns (interest/capital) received on the mortgages are used to pay the interest/capital on the various tranches.
The senior tranche ranks first for payment, then the mezzanine, then the equity tranche get whatever is left over. Typically the senior and mezzanine tranches take the form of fixed-interest bonds.
For example, say the coupon payments on the senior and mezzanine bonds are £10m per year.
If the returns from the mortgages are £28m in a particular year, then the senior tranche may get £10m, the mezzanine £10m and the residual tranche £8m.
If the returns from the mortgages are £19m in a particular year, then the senior tranche may get £10m, the mezzanine £9m (partial default) and the residual tranche get nothing (full default).
Default losses on the mortgages are absorbed first by the equity tranche, then the mezzanine and then the senior tranche.
From the above examples, we can see that the equity tranche investors receive the difference between the actual returns (interest/capital) received on the mortgages and the cost of (interest/capital paid to) the senior and mezzanine tranches.
The senior and mezzanine tranches are priced based on
expected default losses on the mortgages.
The equity tranche investors are therefore hoping that actual default losses on the mortgages are less than the expected default losses. The equity tranche investors are hoping to exploit that differential between actual and expected default losses (ie exploiting a mispricing of the senior / mezzanine tranches).
What's more, the credit spreads on mortgages reflect more than just expected default losses - they also reflect a risk premium for uncertainty over defaults and a liquidity risk premium.
So the equity tranche investors should also be able to capitalise on these risk premia.
Sometimes the equity tranche is retained by the issuer of the CDO rather than offered out to investors. So it is the issuer that benefits from the mispricing, rather than the investors.
Does this help Claire?
Anna
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