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CDOs, Tranching and Attachment Points

A CDO takes one pool of loans or bonds and slices the losses into layers, so that different investors can buy very different risk levels out of the exact same underlying pool.

securitizationstructured-creditcdotranchingcredit-risk

Prerequisites: Asset-Backed Securities, Credit Enhancement, Subordination and Overcollateralization

Pool a hundred risky bonds together and the pool's total losses are far more predictable than any single bond's fate — some will default, most won't, and the total loss rate clusters in a fairly narrow range. A CDO (collateralized debt obligation) exploits that predictability by slicing the pool's losses into layered claims called tranches, and selling each layer to investors with very different risk appetites, all backed by the identical pool.

Tranching doesn't change the pool's total expected loss — it redistributes where losses land. The lowest tranche absorbs losses first and is wiped out early; the top tranche only loses money if losses blow past every layer below it.

Attachment and detachment points

Each tranche is defined by two numbers: where its loss exposure attaches (starts) and where it detaches (ends), expressed as a percentage of the total pool.

  • Equity tranche (0%–5%): absorbs the first 5% of pool losses. Highest yield, highest risk — often unrated, bought by hedge funds or the deal's own sponsor.
  • Mezzanine tranche (5%–15%): loses money only once losses exceed 5%, and is wiped out by 15%. Rated somewhere in the BBB–A range typically.
  • Senior tranche (15%–100%): only takes a loss if more than 15% of the entire pool defaults, uncompensated. Rated AAA/AA, lowest yield.
pool losses climb from the bottom up equity 0–5% mezzanine 5–15% senior 15–100%
Losses fill the pool from the bottom: equity is wiped out first, then mezzanine, and senior investors only see a loss once both layers below are exhausted.

Worked example

A CDO holds a $500 million pool. Over its life, defaults and low recoveries cause total pool losses of 8% of face value.

  1. Total dollar loss. 8% of $500m: 0.08×500=400.08 \times 500 = 40 ($ millions), i.e. $40m.
  2. Equity tranche (0–5%, or $25m of the pool). Fully wiped out — it absorbs the first $25m of the $40m loss, losing 100% of its capital.
  3. Mezzanine tranche (5–15%, or $50m of the pool). Absorbs the remaining loss, 40−25=1540 - 25 = 15 ($ millions), i.e. $15m, a 30% loss on its $50m of capital.
  4. Senior tranche (15–100%). Losses never reach it — it's paid in full, having been protected by $75m of subordination beneath it.

What this means in practice

Tranching is how a single pool of moderate-quality assets can produce both a AAA bond and a high-yield-equivalent equity piece — the credit quality lives in the structure, not just the collateral. The catch is that a tranche's safety depends heavily on how correlated the underlying defaults are: if losses are spread evenly and independently across the pool, subordination works as designed, but if defaults are highly correlated (many loans fail together in a downturn), losses can blow through several tranches at once in a way historical default rates alone don't warn you about.

A tranche's rating describes its position in the loss-absorption order, not the underlying pool's average quality — a senior CDO tranche can be AAA-rated even when built from mezzanine ABS tranches that were themselves only investment-grade, because correlation assumptions, not collateral quality alone, drove the rating. That gap between assumed and realized correlation is exactly what broke down in structured credit during 2007–2008.

Related concepts

Practice in interviews

Probability →

Further reading

  • Choudhry, Structured Credit Products (ch. 6-7)
  • Tavakoli, Collateralized Debt Obligations and Structured Finance (ch. 3)
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