Effect of Coverage Triggers on CDO Tranche Returns

Abstract

Accurately estimating returns on CDO tranches is complicated, particularly when the structure of the CDO contains over-collateralization and interest-coverage triggers. Coverage triggers serve to divert cash flows from more junior tranches to retire principal of senior tranches under conditions of deteriorating collateral pool. We analyzed the effects of typical coverage triggers on distributions of expected tranche returns using Monte Carlo simulation. Results from simulated returns show that coverage triggers increase returns to senior tranche holders, but increase volatility of cash flows from CDOs during their reinvestment periods. Although triggers provide protection to senior holders at the expense of more junior investors, greater alignment of manager incentives with investors in all parts of a deal may serve to increase risk-adjusted returns on the collateral.