Economy & Credit Chest

The senior and mezzanine return profile has an option-like feature, like short puts out-of-the-money (BBB) and far-out-of-the money (AAA) in return terms. When investment grade default rates rise significantly above their long-term historical average, mezzanine notes become impaired. On the other hand, CDS portfolio deterioration causes in general mark-to-market losses and might result in rating downgrades with respect to the notes.

Assumption: The annualized 5-year cumulative BBB credit loss rate is 0.20 percent, assuming a recovery rate of 40 percent. The size of the first loss tranche equals 4 percent, the size of the BBB-note 2.5 percent and the AAA note 3 percent in the example with a portfolio of BBB rated CDS.