Single Tranche CDO
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Single Tranche CDO is a natural extension of full capital structure Synthetic CDO deals. These are bespoke transactions where the bank and the investor work closely to achieve a specific target. In a bespoke transaction, the investor has 100% say on the rating of the tranche, maturity of the transaction, coupon type (fixed or floating), subordination level, type of collateral used etc. Typically the objective is to create a debt instrument where the return is significantly higher than comparably rated bonds. This is also viewed as rating arbitrage, hence these CDOs are also called Arbitrage CDO's. In a nutshell, a single tranche CDO is a CDO where the issuing bank effectively holds the rest of the capital structure and does not place it.
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[edit] Full Capital Structure CDO's
In a full capital structure transaction, the total nominal of the notes issued equals to the total nominal of the underlying portfolio. Therefore, the full capital structure transaction requires all of the tranches being placed with investors.
[edit] Full Capital Structure Deal Example
Consider a USD 1,000,000,000 consisting of 100 entities. Furthermore, consider an SPV which has no assets or liabilities to start with. In order to purchase this USD 1,000,000,000 portfolio it has to borrow USD 1,000,000,000. Instead of borrowing USD 1,000,000,000 in one go, it borrows in tranches and which have different risks associated with them. As an example consider the following transaction:
| Class A | USD 800,000,000 | AAA/Aaa |
|---|---|---|
| Class B | USD 100,000,000 | A+/A1 |
| Class C | USD 70,000,000 | B+/B1 |
| Class D | USD 30,000,000 | Unrated |
| Issuer | SPV Registered in Cayman Islands | |
| Maturity | 5 years | |
| Reference Portfolio | USD 1,000,000,000 total of 100 entities | |
Class D notes are not rated and they are called equity or the first loss piece. As soon as there are defaults within the portfolio, the principal of the Class D notes are reduced with the corresponding amount. If there are a total of USD 12,000,000 of losses in the portfolio during the life of the deal, Class D noteholders receive only USD 18,000,000 back, having lost USD 12,000,000 of their capital. Class A, B, and C noteholders receive all of their money back. However, if there are USD 42,000,000 of losses in the portfolio during the life of the transaction then the entire capital of the Class D noteholders is gone and the Class C noteholders receive only USD 58,000,000.
[edit] What Drives Full Capital Structure Deals?
The investor who has most at risk is the equity investor. In the above example this is the investor of the Class D notes. The equity piece is the most difficult part of the capital structure to place. Therefore the equity investor has the most say in shaping up a full capital structure deal. Typically the sponsor of the CDO will take a portion of the equity notes with the condition of not selling them until maturity to demonstrate that they are comfortable with the portfolio and expect the deal to perform well. This is an important selling point for the investors of mezzanine and senior notes.
[edit] Structure of Full Capital Structure Deals
In synthetic transactions, credit risk of the Reference Portfolio is transferred to the SPV via credit default swaps. For each name in the portfolio the SPV enters into a credit default swap where the SPV sells credit protection to the bank in return for a periodically paid premium. The cash raised from the sale of the various classes of notes, i.e.; Class A, B, C and D in the above example, is placed in collateral securities. Typically these are AAA rated notes issued by supranationals, governments, governmental organizations, or covered bonds (Pfandbrief). These are low risk instruments with a return slighly below the interbank market yield. If there is a default in the portfolio, the credit default swap for that entity is triggered and the bank demands the loss suffered for that entity from the SPV. For example if the bank has entered into a credit default swap for USD 10,000,000 on Company A and this company is bankrupt the bank will demand USD 10,000,000 less the recovery amount from the SPV. The recovery amount is the secondary market price of USD 10,000,000 of bonds of Company A after bankruptcy. Typically recovery amount is assumed to be 40% but this number changes depending on the credit cycle, industry type, and depending on the company in question. Hence, if recovery amount is USD 4,000,000 (working on 40% recovery assumption), the bank receives USD 6,000,000 from the SPV. In order to pay this money, the SPV has to liquidate some collateral securities to pay the bank. Having lost some assets, the SPV has to reduce some liabilities as well and it does so by reducing the notional of the equity notes. Hence, after the first default in the portfolio, the equity notes, i.e.; Class D notes in the above example are reduced to USD 24,000,000 from USD 30,000,000.
[edit] Single Tranche CDO
A typical Single Tranche CDO is a note issued by a bank or an SPV where in addition to the credit risk of the issuing entity, the investors take credit risk on a portfolio of entities. In return for taking this additional credit risk on the portfolio, the investors achieve a higher return than the market interest rate for the corresponding maturity. A typical Single Tranche CDO will have the following terms depending on whether it is issued by the bank or by the SPV:
| Issuer | MyBank |
|---|---|
| Nominal | USD 10,000,000 |
| Maturity | 5 years |
| Coupon | USD 6m Libor + 1.00% |
| Rating | A+/A1 |
| Reference Portfolio | USD 1,000,000,000 portfolio of 100 investment grade entities based in USA and Canada |
| Attachment Point | 5% |
| Detachment Point | 6% |
| Issuer | CDO Company I Cayman Islands Ltd. |
|---|---|
| Nominal | USD 10,000,000 |
| Maturity | 5 years |
| Rating | A+/A1 |
| Collateral | 5yr MTN issued by the International Bank for Reconstruction and Development (World Bank) rated AAA/Aaa |
| Coupon | USD 6m Libor + 1.00% |
| Reference Portfolio | USD 1,000,000,000 portfolio of 100 investment grade entities based in USA and Canada |
| Attachment Point | 5% |
| Detachment Point | 6% |
[edit] How does it work?
In the above example, the investor is making a USD 10,000,000 investment. He will receive USD 6month Libor + 1.00% as long as the cumulative losses in the Reference Portfolio remain below 5%. If for example at the end of the transaction the losses in the portfolio remain below 5% the investor will receive USD 10,000,000 back. If however, the losses in the portfolio is USD 52,000,000 which corresponds to 5.2% the investor will lose 20% of his capital, i.e. he will receive only USD 8,000,000 back. The coupon he receives will be on the reduced notional from the moment the portfolio suffers a loss that affects the investor.
