Break-Even Default Rate (BDR)
Definition
Break-Even Default Rate measures the cumulative default rate required to reduce a CLO tranche's total return to zero—accounting for coupon income earned before defaults occur. BDR is calculated as (Subordination % + Cumulative Coupons) / (1 - Recovery Rate). For example, a BBB tranche with 20% subordination, earning 4% annual coupon over 5 years (20% cumulative), assuming 40% loss severity, has BDR = (20% + 20%) / 40% = 100%. This means the portfolio must experience 100% cumulative defaults with 40% loss severity before the BBB tranche faces principal impairment. BDR provides intuitive risk metric—higher BDR indicates more cushion.
Why it matters
BDR translates complex subordination math into actionable default tolerance, enabling risk-adjusted pricing decisions. A BBB tranche with 80% BDR means the portfolio can sustain 80% cumulative defaults (vs historical 10-30% stress default rates) before investor loses money. This explains why BBB CLO tranches rarely default despite meaningful credit risk—the subordination buffer plus coupon cushion creates substantial protection. However, BDR analysis has critical limitations: assumes uniform timing (but defaults front-loaded hurt more), assumes static recovery (but recoveries collapse during stress), and ignores liquidity risk (mark-to-market losses occur before ultimate default). During March 2020, BBB tranches with 100%+ BDRs traded at 70-80 cents despite fundamental BDRs intact—illustrating mark-to-market risk overwhelms break-even math during dislocations.
Common misconceptions
- •High BDR doesn't mean zero risk—it measures default tolerance but ignores mark-to-market, extension risk, and refinancing risk. A tranche can have 100% BDR but trade at 70 cents.
- •BDR calculations assume pro rata timing. Front-loaded defaults consume subordination before earning coupon cushion, reducing effective BDR by 20-30%.
- •Recovery assumptions are critical. Changing recovery from 70% to 60% (10 point LGD increase) reduces BDR by 33% even with identical subordination.
Technical details
BDR calculation methodology
Basic formula: BDR = (Subordination + Cumulative Coupons) / Loss Given Default. Components: 'Subordination' = % of capital structure junior to tranche, 'Cumulative Coupons' = annual coupon × years to maturity, 'Loss Given Default' = 1 - Recovery Rate.
Example 1 - AAA tranche: 60% AAA tranche, L+130 coupon (6.3% all-in), 10-year maturity, 70% recovery assumption (30% LGD). Subordination = 40%, Cumulative Coupons = 6.3% × 10 = 63%, BDR = (40% + 63%) / 30% = 343%. Portfolio must experience 343% cumulative defaults to impair AAA (impossible—implies 3.4× defaults of entire portfolio).
Example 2 - BBB tranche: 10% BBB tranche at 18-28% of capital structure, L+500 coupon (10% all-in), 10-year maturity, 70% recovery (30% LGD). Subordination = 18%, Cumulative Coupons = 10% × 10 = 100%, BDR = (18% + 100%) / 30% = 393%. Extremely high cushion explains why BBB tranches rarely default.
Example 3 - Equity: 8% equity position, no subordination (residual claim), no fixed coupon. BDR effectively zero—first dollar of losses impacts equity through NAV decline. Equity has negative BDR concept—must achieve 0% defaults to earn target returns.
Timing effects and front-loaded default scenarios
Static BDR assumes uniform default timing: If 40% cumulative defaults occur evenly over 10 years (4% annually), tranche earns full coupon stream offsetting losses. In reality, defaults concentrate in years 3-7 of CLO life, creating timing mismatch.
Front-loaded default scenario: 40% of portfolio defaults in years 1-3. Tranche earns only 3 years of coupons (30% cushion vs 100% in 10-year case) before facing losses. Effective BDR = (Subordination + 30%) / 30% = significantly lower than static calculation.
Implication for pricing: Tranches with 5-year maturity (30% cumulative coupons) versus 10-year maturity (100% cumulative coupons) have materially different BDRs despite identical subordination. Shorter duration tranches require tighter credit or more subordination for equivalent protection.
Recovery timing matters too: Defaults occurring in year 2 but recovery realization in year 5 create present value losses even if ultimate recovery matches assumptions. Time value of money reduces effective BDR by 15-25% in realistic scenarios.
Stress testing and scenario analysis
Historical default rate benchmarks: Great Financial Crisis (2008-2009) = 35-40% cumulative CLO defaults over 5 years. COVID-19 (2020-2021) = 8-10% cumulative defaults. Normal environment = 10-15% over full life. Comparing BDR to these benchmarks provides stress cushion visibility.
Severe recession scenario: 50% cumulative defaults, 50% recovery (50% LGD vs 30% assumption). BBB tranche with 100% BDR under normal assumptions has effective BDR = (18% + 100%) / 50% = 236% under stress—still safe but cushion materially eroded. AAA remains extremely safe (500%+ effective BDR).
Depression scenario: 70% cumulative defaults, 40% recovery (60% LGD). BBB effective BDR = (18% + 100%) / 60% = 197%. Still impairment-free but illustrates importance of recovery assumptions. If recoveries fall to 30% (70% LGD), BDR drops to 169%.
Sensitivity analysis: BBB tranche with 18% subordination, 100% cumulative coupons. Recovery 70% (30% LGD) → BDR 393%. Recovery 60% (40% LGD) → BDR 295% (25% lower). Recovery 50% (50% LGD) → BDR 236% (40% lower). Recovery is more impactful than default rate in many scenarios.
Limitations and mark-to-market considerations
BDR measures ultimate impairment, not interim volatility: BBB tranche with 100% BDR might trade at 60-80 cents during stress despite zero fundamental impairment risk. Mark-to-market losses occur long before default, creating optionality for distressed buyers.
Refinancing risk ignored: Many tranches have 2-3 year non-call periods but ultimately refinance. If spreads widen materially, refinancing at disadvantageous terms creates losses even with zero defaults. BDR doesn't capture refinancing risk—relevant for 5-7 year paper refinanced at peak spreads.
Liquidity premium during stress: March 2020 saw BBB tranches with 150%+ BDRs trade at L+1200 (vs L+500 issuance). 700 bps widening reflected liquidity premium, forced selling, and worst-case assumptions—not fundamental default expectations. BDR provided no protection against liquidity-driven losses.
Extension risk for junior tranches: Equity and mezzanine face extension when defaults trigger cash diversion. Instead of 7-year expected life, structure extends to 12 years. Time value losses occur even with principal ultimately recovered. BDR math doesn't capture present value destruction from extension.