In Schweser notes, the Equity/Subordinate tranche isn’t explained too well and I’m hoping to get a better understanding of it. All as it’s really explained is that it provides credit and prepayment protection to senior tranches – there’s gotta be more to it than just that! To fund that subordinate section of the CDO, an investor has to be willing to put capital out there to bear those risks, which seem quite large. My question is what is the return potential on these equity/subordinate tranches? I’d have to guess it’s quite large (potentially).
For a CDO that just has high yield corporate bonds, MBS and emerging market bonds there doesn’t seem to be much upside potential in that asset pool (there would have to be some other assets in there to attract investors willing to take all of that risk). The more senior tranches are getting paid their income from these assets and the equity tranche takes the credit risk but not much upside with just high yield bonds. Are the equity tranches getting their return potential from hybrid instruments with equity kickers, such as warrants, convertible bonds and distressed debt that may eventually turn into equity? I’d think you’d have to have that type of upside assets in there to attact equity tranche investors to compensate them for their risk. This section of a CDO seems like it’d require a lot of due diligence if so.
I’m sure each CDO is quite unique when it comes to the equity section, but any type of conceptual explanation would be helpful. Thanks for your time!