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Tranching and Rating


  • We thank seminar participants at the Königsfeld workshop, Risk Management Institute in Singapore, an anonymous referee, and the Enterprise Risk Symposium in Chicago for many helpful suggestions. The paper was also presented at the 11th Symposium on Finance, Banking, and Insurance at the University of Karlsruhe, December 2008, and at the Melbourne Derivatives Research Group Conference, April 2009. Correspondence: Michael Brennan.


In this paper we analyse the source and magnitude of marketing gains from selling structured debt securities at yields that reflect only their credit ratings, or specifically at yields on equivalently rated corporate bonds. We distinguish between credit ratings that are based on probabilities of default and ratings that are based on expected default losses. We show that subdividing a bond issued against given collateral into subordinated tranches can yield significant profits under the hypothesised pricing system. Increasing the systematic risk or reducing the total risk of the bond collateral increases the profits further. The marketing gain is generally increasing in the number of tranches and decreasing in the rating of the lowest rated tranche.