Mezzanine Tranches

Why increasing correlation at low default rates decreases mezzanine bond values and at high default default rates increases mezzanine bond values?

Thanks in advance

Check out the following link which connects to a 2004 paper by Michael Gibson to see if this helps you:

Go directly to Page 18 and read the paragraph that begins: “The effect of correlation on CDO tranches is intuitive…” and then check out the graph on Page 19 which helps to visualize the push-and-pull of correlation effects on equity, mezz and senior tranches.

If I think I understand your question correctly, this might help to clear it up. Notice that since the mezzanine tranches are in the middle, they experience a mixed bag of effects depending on whether they are at the end of the correlation spectrum where equity effects are strongest, or senior tranche effects are strongest, generating a “U” shape to the valuation curve for a mezz tranche. The equity tranche value function only continuously increases with higher correlations and the senior tranche value function only continuously decreases with higher correlations.

Hope this helps.