CFA Level II ExamFixed IncomeMedium
A portfolio manager is analyzing a collateralized debt obligation (CDO) with multiple tranches. The CDO is backed by a pool of corporate bonds. The manager is particularly interested in understanding how the risk of the underlying assets is distributed among the different tranches. Which of the following statements best describes the typical risk allocation in a CDO structure?
- AJunior tranches have lower credit risk and receive principal payments before senior tranches.
- BMezzanine tranches bear the first losses and offer the highest credit enhancement to junior tranches.
- CSenior tranches have the lowest credit risk and receive principal payments after junior tranches.
- DEquity (or unrated) tranches absorb the first losses and provide credit enhancement to all other tranches.
Show answer & explanationAnswer & explanation
Correct answer: D. Equity (or unrated) tranches absorb the first losses and provide credit enhancement to all other tranches.
In a typical CDO structure, the equity (or unrated) tranche is the most junior tranche and absorbs the first losses from the underlying collateral pool, thereby providing credit enhancement to the more senior tranches. As a result, it also has the highest potential return.
Why the other options are wrong
- A. Junior tranches have higher credit risk and receive payments after senior tranches.
- B. Equity tranches, not mezzanine tranches, bear the first losses.
- C. Senior tranches receive principal payments before junior tranches.
CDO Tranche Risk Allocation
Collateralized Debt Obligations (CDOs) divide the cash flows and risk of an underlying asset pool into multiple tranches with varying levels of seniority and risk.
- Equity/unrated tranches absorb first losses.
- Mezzanine tranches absorb losses after equity.
- Senior tranches have the lowest risk and highest credit rating.
Memory trick: Equity first, Mezzanine next, Senior last in line for loss.