CFA Level II ExamFixed IncomeMedium
A portfolio manager is considering investing in a collateralized debt obligation (CDO) that consists of various tranches. The manager is particularly interested in a junior tranche, which offers a very attractive yield but has a lower credit rating than the senior tranches. Which of the following statements most accurately describes the risk profile of this junior tranche compared to a senior tranche in the same CDO structure?
- AThe junior tranche has lower credit risk and higher call protection.
- BThe junior tranche offers a lower yield due to its superior credit quality.
- CThe junior tranche has higher credit risk and is more sensitive to defaults in the underlying collateral.
- DThe junior tranche has lower interest rate risk and higher liquidity.
Show answer & explanationAnswer & explanation
Correct answer: C. The junior tranche has higher credit risk and is more sensitive to defaults in the underlying collateral.
Junior tranches in a CDO absorb losses first from the underlying collateral pool. This means they bear the highest credit risk and are most sensitive to defaults occurring within the collateral. To compensate for this higher risk, they typically offer a higher yield.
Why the other options are wrong
- A. Junior tranches have higher, not lower, credit risk and typically no special call protection compared to senior tranches.
- B. Junior tranches offer a higher, not lower, yield to compensate investors for their substantially higher credit risk.
- D. Liquidity is generally lower for junior tranches due to their complexity and higher risk, and interest rate risk is not inherently lower.
CDO Tranche Risk
In a Collateralized Debt Obligation (CDO), tranches are layers of securities with different seniority levels, allocating risk and return from the underlying collateral pool. Junior tranches absorb losses first, bearing higher credit risk.
- Senior tranches have the lowest credit risk and lowest yields.
- Mezzanine tranches have moderate credit risk and moderate yields.
- Equity/Junior tranches have the highest credit risk and highest potential yields.
Memory trick: Junior's first to fall, senior stands tall.