These are bespoke transactions where the bank and the investor work closely to achieve a specific target.
In a bespoke portfolio transaction, the investor chooses or agrees to the list of reference entities, the rating of the tranche, maturity of the transaction, coupon type (fixed or floating), subordination level, type of collateral assets used etc.
Typically the objective is to create a debt instrument where the return is significantly higher than comparably rated bonds.
If there are a total of $12,000,000 of losses in the portfolio during the life of the deal, Class D noteholders receive only $18,000,000 back, having lost $12,000,000 of their capital.
Typically the sponsor of the CDO will take a portion of the equity notes with the condition of not selling them until maturity to demonstrate that they are comfortable with the portfolio and expect the deal to perform well.
Typically these are AAA rated notes issued by supranationals, governments, governmental organizations, or covered bonds (Pfandbrief).
According to researchers at Joseph L. Rotman School of Management, the [1]Tranches of nonstandard portfolios are regularly traded.
If however, the losses in the portfolio amount to $52,000,000, which corresponds to 5.2% of pool notional, the investor will lose 20% ($2,000,000) of his capital, i.e. he will receive only $8,000,000 back.
The coupon he receives will be on the reduced notional from the moment the portfolio suffers a loss that affects the investor.