Explain how structured products can stand in for corporate bonds in a credit portfolio
The idea
Mortgage-backed and asset-backed securities, collateralised loan obligations and covered bonds give credit exposure to borrowers other than the corporate issuers that dominate bond indexes, adding diversification. Tranching redistributes credit risk: senior tranches carry high ratings and little default risk, while mezzanine and equity tranches absorb losses first and pay higher yields. MBS add prepayment risk and negative convexity, making them effectively short volatility. Covered bonds keep the assets on the issuer's balance sheet and give investors recourse to both the issuer and the cover pool. CLOs offer floating-rate exposure to leveraged loans. The trap is relying on the rating alone: tranche losses depend on how correlated defaults are within the pool, and senior tranches can suffer when that correlation rises.
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