Fixed Income2

The key to a CDO’s viability is the creation of a structure with a competitive return for the:

  1. senior tranche.
  2. mezzanine tranche.
  3. subordinated tranche.

The answer
is 3
can someone help how?

In a waterfall structure , the jr. most tranche is the riskiest piece and hence warrants the highest yield. The protection against default is columnar in nature with the sr. most tranche enjoying the highest level of protection.

That being the case, it is safe to assume you are as strong as your weakest player in the team. So if the Jr. tranche is competitively priced (i.e. the lower the yield will exert lesser burden on the issuer), the greater the reliability of it sustaining. On the contrary of the issuer is forced to issue the jr. tranche at an excessively high yield as compared to the rest of the structure above it , the likelihood of that protection being busted increases manifold.