Explain why the credit spread typically paid on an A-rated tranche of a collateralized debt obligation (CDO)

Explain why the credit spread typically paid on an A-rated tranche of a collateralized debt obligation (CDO) is greater than the credit spread typically paid on an A-rated corporate bond of the same maturity.

Expert Solution

Credit spread which is typically paid upon a higher tranche of collateralized debt obligation is greater than the credit spread generally paid upon corporate Bond because in collateralized debt obligations, there are various types of instruments which are combined together and these are not having an exclusive corporate debt instrument but these are a combination of various debt instruments so these are also having substandard kind of debt instrument embedded in it so all these higher tranche of collateralized debt obligation will be having a higher rate of interest because these are easily differentiated from the other branch because the other branch are Sub standard in relation to the A-rated branch and hence it will be having a higher credit spread

In case of Corporate Bond, these different branches will be having similar characteristic because they are not combined together having different characteristics and qualities because they are not having sub standard quality of debt instrument present with them and hence, They will be having equal credit spread for all and hence the collateralized debt obligation credit spread will be higher than the normal corporate bonds.

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