A collateralised loan obligation, an agency mortgage pass-through and a non-agency mortgage bond all belong in the same conversation as a corporate bond, because they all consume the same risk budget. What differs is where the convexity sits and which of the two arithmetics above applies.
How does a CLO allocate losses?
A collateralised loan obligation slices a pool of leveraged loans into tranches by attachment point. The mechanics of the waterfall belong with the securitisation work; what an active manager needs is the loss-allocation arithmetic, which is a single line of subtraction. Take a $500m pool with subordinated notes at 0 to 10%, a BB class at 10 to 12.5%, a BBB at 12.5 to 16%, an A at 16 to 22%, an AA at 22 to 30% and a AAA above 30%.
| Scenario | Default rate | Recovery | Pool loss | Where it lands |
|---|---|---|---|---|
| Base | 18.0% | 62.0% | 6.8400% = $34.2m | Subordinated notes written down 68.40%; every rated class whole |
| Stress | 35.0% | 45.0% | 19.2500% = $96.25m | Subordinated, BB and BBB wiped; A written down 54.17%; AA and AAA whole |
In the base case the first untouched class attaches at 10% against a 6.84% loss, a cushion of 1.4620 times. That multiple, not the rating, is what a manager should quote when asked how safe the tranche is, because it says what has to happen rather than what an agency believes.
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How do mortgage bonds differ from CLO tranches?
Mortgages are the other half and they carry the opposite kind of risk. An agency pass-through has almost no credit risk and a great deal of negative convexity, because the borrowers hold a free prepayment option and exercise it when rates fall. A non-agency bond has credit risk and its convexity is dominated by the loss path rather than the prepayment path. So an active manager buying agency mortgages is being paid an option premium and should think in option terms, and one buying non-agency is running credit and should think in DTS and breakeven-widening terms. Applying the wrong frame to either is a reliable way to be surprised.
The single sentence worth carrying: in structured credit the position's risk is set by where it attaches in the loss stack and by whose option it has written, and neither of those is visible in the yield.