Single-tranche CDO

Single-tranche CDO or Bespoke CDO is an extension of full capital structure synthetic CDO deals, which are a form of collateralized debt obligation. These are bespoke transactions where the bank and the investor work closely to achieve a specific target.

In a bespoke portfolio transaction, the investor chooses or agrees to the list of reference entities, the rating of the tranche, maturity of the transaction, coupon type (fixed or floating), subordination level, type of collateral assets used etc. Typically the objective is to create a debt instrument where the return is significantly higher than comparably rated bonds. In a nutshell, a single-tranche CDO is a CDO where the arranging bank does not simultaneously place the entirety of the capital structure. These CDOs are also called arbitrage CDOs because the arranging bank seeks to pay a lower return than the return available from hedging the single-tranche exposure.

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.

Consider a US$1,000,000,000 portfolio consisting of 100 entities. Furthermore, consider an SPV which has no assets or liabilities to start with. In order to purchase this $1,000,000,000 portfolio it has to borrow $1,000,000,000. Instead of borrowing $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 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 principals of the Class D notes are reduced with the corresponding amount. If there are a total of $12,000,000 of losses in the portfolio during the life of the deal, Class D noteholders receive only $18,000,000 back, having lost $12,000,000 of their capital. Class A, B, and C noteholders receive all of their money back. However, if there are $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 $58,000,000.

The investor who is 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.

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