Comparing the LIBOR spread isn't enough to compare senior subprime tranches to senior prime tranches. Among other things, the attachment point matters a very a great deal.
The attachment point is the % of cumulative losses after which a given tranche starts suffering losses of principal. So for example:
L+20 with a 20% attachment point against historical max losses in the asset class over all credit cycles of 1% is a lot better on a risk adjusted basis than L+200 with a 40% attachment point against historical max loss experience of 15%.
Without talking about historical loss experience we can't really guesstimate the margin of safety here nor say that a given tranche is or isn't good value.
Another possibly interesting nitpick: LIBOR isn't risk-free. It's an interbank rate so it is the short-term yields paid by highly rated financial institutions. Risk free means backed by an entity that can print money, like the Fed. That's why the LIBOR-Fed Funds basis exists.
Also, re: "I think it's interesting how high interest rate risky loans can be considered as sleazy while giving opportunities to the less fortunate is considered an admirable goal." check out the book _Scarcity_ by Mullanaithan and Shafir, which has a super interesting take on this question!
Completely agree with everything you said. I was only calling libor risk-free as it is what would be substituted for the risk free rate used in finance textbooks. Technically it's not risk-free but serves as a base return to benchmark off of. Also, most of these bonds pay coupons linked to libor.
Attachment and detachment point are definitely very important. I found a random fed document from 2012 that suggests similar attachment/detachment points for AAA prime vs subprime abs securities (~79% attachment). I haven't looked at it too closely though and I could be missing something. I know spreads are a lot tighter since 2012 and credit quality of underlying loans may have worsened with lower standards. On the other hand, people are a lot better off now that in 2012 (i.e. stock market, housing market, etc).
Will check out Scarcity. Thanks for the recommendation!
Well, if you're talking about LIBOR, the risk is that the AA bank to whom you have counterparty risk will default within 3mo, so it's very, very, very low risk.
The attachment point is the % of cumulative losses after which a given tranche starts suffering losses of principal. So for example:
L+20 with a 20% attachment point against historical max losses in the asset class over all credit cycles of 1% is a lot better on a risk adjusted basis than L+200 with a 40% attachment point against historical max loss experience of 15%.
Without talking about historical loss experience we can't really guesstimate the margin of safety here nor say that a given tranche is or isn't good value.
Another possibly interesting nitpick: LIBOR isn't risk-free. It's an interbank rate so it is the short-term yields paid by highly rated financial institutions. Risk free means backed by an entity that can print money, like the Fed. That's why the LIBOR-Fed Funds basis exists.
Also, re: "I think it's interesting how high interest rate risky loans can be considered as sleazy while giving opportunities to the less fortunate is considered an admirable goal." check out the book _Scarcity_ by Mullanaithan and Shafir, which has a super interesting take on this question!