A single tranche CDO is one that uses credit defaults swaps in its portfolio of assets and issues only one tranche tailored for a single investor instead of issuing the entire capital structure to a variety of investors. The single tranche is in the form of a credit default swap. It may also be offered in note format by creating a credit-linked note referenced to the tranche swap.
Bespoke single tranches are almost always cash-settled. When there is a default in the portfolio, the calculation agent (usually the protection buyer) calculates the recovery rate for the credit and determines the loss as a percentage of the portfolio. However, the protection seller only needs to make a payment once losses exceed the ‘attachment point’. Once losses reach the detachment point, the protection seller’s investment is wiped out and the protection buyer no longer enjoys any protection on the portfolio.
For example, an insurance company might invest in a €20 million 5% to 6% tranche of a portfolio of 100 equal-weighted investment grade credits with a dealer as the buyer of protection. The dealer pays a premium of 50bp a year to the insurance company, and the first few defaults in the portfolio do not affect the investment. After the 10th default (based on 50% recovery rates for the various defaults), losses in the portfolio will hit the 5% tranche attachment point.
If, for example, the 11th default brings losses in the portfolio to 5.4%, the insurance company’s investment will be written down to €12 million and the 50bp protection payments will made on the reduced €12 million notional.
Most single tranches are rated – though, unlike cashflow CDOs, the rating is usually given by only one rating agency – and the deal in this example could expect to achieve a double A or triple A rating, depending on the exact composition of the portfolio. This high rating implies that it is unlikely for the deal to suffer any loss.