A Bespoke Tranche Opportunity, also known as Bespoke Tranche or Collateralized Debt Obligation (CDO), is a dealer-created, structured financial product tailored to the needs of a specific group of investors. Generally, a single tranche of the bespoke tranche opportunity is bought by the investor. The left over tranches are used as a hedge against losses, and are held by the dealer. In case you are unfamiliar with the term tranche, it’s nothing but a chunk or a portion of a pooled asset separated based on specific characteristics.
A traditional bespoke tranche opportunity/collateralized debt obligation (CDO) pools a group of assets (mortgages, bonds, loans etc.) which generate cash flow and then it repackages the portfolio bearing the aforementioned assets into discrete sections or tranches. Bespoke tranche opportunities/CDOs can be structured similarly to traditional CDOs, where income streams are pooled with classes of debt, however that term is usually reserved for synthetic CDOs, the kind that focus on investing in Credit Default Swaps (CDS).
The different parts or tranches of a bespoke tranche opportunity/CDO come with different levels of risk, which is governed by the credit-worthiness of the underlying asset. As a result of that, every tranche of a bespoke tranche opportunity provides different quarterly rate of returns (RoR). The more a tranche’s holdings are susceptible to default, the higher will be the return offered by it. Bespoke tranche opportunities are usually not graded by major rating agencies and the evaluation of their credit-worthiness is usually carried out by the issuer and to an extent, market perception. Bespoke Tranche Opportunities are usually traded over the counter (OTC).
Bespoke tranche opportunities/CDOs, like all other types of CDOs became disgraced in public view due to their pivotal role in the financial crisis that ensued after the mortgage meltdown which happened between 2007 and 2009. Wall Street‘s creation of these structured financial products was seen as the major contributor to the massive market crash and the inevitable bailout by the Government. These products were highly structured while being extremely complicated to understand and evaluate for both the buyers and the sellers. The 2015 movie The Big Short, starring Brad Pitt, Steve Carell, Ryan Gosling and Christian Bale showcased the origins and impact of bespoke tranche opportunities/CDOs in an amazing way.
Despite all the negative press associated with them, bespoke tranche opportunities/CDOs are still very useful tools for freeing up capital and transferring risk to parties that have a higher appetite for it. After all, one of the perennial quests of Wall Street is finding newer and better ways to transfer risk and unlock capital. As a result of that, bespoke CDOs have been on a comeback trail since 2016. But to avoid the taboo associated with the name, they are mostly referred to as bespoke tranche opportunities now.
The rebranding and renaming of bespoke CDOs to bespoke tranche opportunities hasn’t really changed the machinations of the financial tool itself. However, the pricing models have presumably undergone a bit more scrutiny this time. Bespoke tranche opportunities are expected to alleviate the biggest problem of the original bespoke CDOs, which was investors holding on to obligations they didn’t properly understand. If you were wondering whether bespoke tranche opportunities have been accepted by today’s investors or not, here’s a fun fact, $50 billion worth of bespoke tranche opportunities were sold in the year 2017.
One of the leading dealers of bespoke tranche opportunities is the Citigroup. It dealt $7 billion worth of them in 2016 by itself. As per Vikram Prasad, Citigroup’s managing director of Correlation and Exotics Trading, the firm offers a standardized portfolio of credit default swaps in order to increase transparency in what “has historically been an opaque market”. The portfolio features the assets which make up the bespoke tranche opportunity. Citigroup has also made the pricing structure of the tranches visible and completely accessible on its client portal.
Advantages and disadvantages of bespoke tranche opportunities
The biggest and most obvious advantage of a bespoke tranche opportunity is that it is completely customizable for the buyer. A bespoke tranche opportunity is a tool that helps with their investment strategies and hedging requirements by targeting very specific risk-to-return profiles. No matter what investors want to put their money on, a dealer can create a bespoke tranche opportunity for the right price.
The second advantage is the high yield or returns. Another ancillary advantage is the diversified nature of the tool.
The biggest disadvantage of a bespoke tranche opportunity is the complete lack of a secondary market which in turn makes daily pricing a very difficult task. Instead, complex theoretical financial models are used to calculate the value. These models can make catastrophically wrong assumptions.
The highly customized nature of bespoke tranche opportunities make it very unappealing to some other investors. One needs to be very lucky to find another investor who has the same exact investment ideas.
Bespoke tranche opportunities are unregulated products and thereby carry a large amount of risk. The lack of transparency and liquidity doesn’t help either.