Final answer:
Certain tranches of collateralized loan obligations offer higher yields than their underlying collateral due to the risk-return tradeoff, whereby investors demand higher returns for assuming greater default risk. These tranches are structured to absorb varying levels of risk, with higher yields acting as compensation for the greater potential loss. This principle is consistent across various fixed-income securities, such as high-yield bonds and corporate bonds.
Step-by-step explanation:
The question concerns why certain tranches of collateralized loan obligations (CLO) have higher yields than the underlying collateral. Essentially, this can be attributed to the risk-return tradeoff, where higher yields compensate investors for the increased risk of default. These tranches are structured to absorb different levels of default risk, with lower tranches taking on more risk and therefore offering higher yields to attract investors. This concept is common in fixed-income securities, including high-yield bonds, which offer higher interest rates to compensate for their greater risk of default.
Investment banks often bundle loans into collateralized debt obligations (CDOs), introducing layers of risk through tranching. Investors in lower tranches are exposed to greater risk and thus receive higher yields as potential compensation. The risk is higher because these tranches are the first to absorb losses in case of borrower defaults. As a result, they yield more than the safer, higher-ranking tranches or the underlying collateral.
In the broader context, corporate bonds, as explained by Moody's ratings, usually provide higher yields compared to federal government-issued Treasury bonds since firms are considered riskier borrowers. The same principle applies to CLO tranches: the higher the perceived risk, the higher the yield investors demand in exchange for taking on that risk. This underscores the fundamental economic principle that investors require higher returns to compensate for greater risk.