What it means
A traditional collateralised debt obligation pools many loans or bonds, then divides the cash flows into layers called tranches, with the lowest tranche absorbing the first losses. Investors buy whichever layer matches their appetite, and every layer must be sold for the deal to work.
A bespoke CDO strips that process down. The investor names the reference companies, chooses which band of losses to take, and the bank sells that single tranche while managing its own exposure to the rest, usually through offsetting trades rather than by finding other buyers.
This matters because it lets an institution take a very precise position that no off-the-shelf product offers, such as exposure to the fourth through eighth per cent of losses on a basket of European industrial borrowers. Pension funds and insurers have used these structures to pick up extra yield without buying the underlying bonds outright.
The economics run on two numbers: the attachment point, the level of portfolio loss at which the investor starts losing money, and the detachment point, where the investor's loss is complete. In between, losses pass through proportionally, so a thin tranche can be wiped out by a small move in defaults while a wide one absorbs damage more gently.
The important nuance is that these instruments are illiquid and hard to value independently, because the price depends heavily on assumed correlation between the reference companies. Correlation is not directly observable, so two reasonable analysts can produce very different values for the same tranche, which is precisely what caused so much difficulty in the 2007 to 2009 credit crisis.
In practice
Real-world examples.
Example
An insurance company wants investment-grade yield without buying forty individual bonds and settling forty separate trades. It buys a $20 million bespoke tranche referencing those same forty names, receiving a quarterly premium in exchange for taking a defined band of default losses.
Example
A bank has accumulated concentrated credit exposure to European utilities through its lending book. It arranges a bespoke tranche with a hedge fund that transfers the first losses on that specific pool, reducing regulatory capital without asking any borrower for consent.
Example
A multi-strategy hedge fund believes defaults will cluster more than the market assumes. It sells protection on a senior tranche and buys protection on a junior one referencing the same basket, expressing a pure view on correlation rather than on the overall default rate.
Formula
Calculation
Tranche loss (%) = min(max(Portfolio loss % - Attachment %, 0), Detachment % - Attachment %) / (Detachment % - Attachment %), and Tranche loss ($) = Tranche loss (%) x Tranche notional.
Consider a reference portfolio of $500 million spread across 100 corporate names, with an investor buying the 3% to 7% tranche. The tranche width is 7% - 3% = 4%, so the tranche notional is 4% x $500 million = $20 million. In dollar terms the investor is exposed to portfolio losses between $15 million and $35 million.
Now suppose defaults and recoveries produce a portfolio loss of 5%, which is 5% x $500 million = $25 million. That is $25 million - $15 million = $10 million above the attachment point. As a percentage of the tranche, the loss is (5% - 3%) / 4% = 2/4 = 50%, so the investor loses 50% x $20 million = $10 million and keeps $10 million of principal. If the coupon were 500 basis points, the annual premium received would be 5% x $20 million = $1 million.Case study
Seen in the real world.
This is a fictional, illustrative scenario. Halversen Structured Products, an invented dealer, arranged a bespoke tranche for a mid-sized pension scheme that wanted an extra 200 basis points of yield above corporate bonds. The scheme took the 3% to 7% band on a basket of 100 investment-grade names and was told, correctly, that historical default rates in that basket had never come close to breaching 3%.
Two years later a sector downturn pushed a cluster of related borrowers into default at the same time. The portfolio loss reached 5%, which meant half of the scheme's $20 million was gone, and the mark-to-market value fell further still as correlation assumptions across the market were revised upward.
The illustrative lesson is that the risk in these structures is rarely the headline default rate. It is the possibility that defaults arrive together rather than spread out, and that the investor is holding an instrument almost nobody else will price or buy.
Watch out
Common mistakes.
- Assuming a highly rated bespoke tranche is as safe as a highly rated corporate bond. The rating reflects modelled loss under assumptions that can shift sharply.
- Ignoring correlation and focusing only on the average default probability of the reference names. Clustered defaults are what destroy junior and mezzanine tranches.
- Treating the quoted mark as a price you could actually trade at. These are one-off contracts with no active secondary market and wide exit costs.
Questions
People also ask.
How is a bespoke CDO different from an ordinary CDO?
Only the tranche the client wants is issued, the reference names are chosen by the buyer, and the bank hedges the remainder itself rather than selling every layer.
Do these still exist after the financial crisis?
Yes, in a smaller and more heavily collateralised form, often marketed as bespoke tranche opportunities to institutional buyers.
Why is a thin tranche riskier than a wide one?
Because a small change in portfolio losses moves through the whole width of a thin tranche, so it can go from untouched to fully written off very quickly.
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