wilmott.com

Must every CDO contain a subordinated, non-rated tranche?

Any time you break up cash flows into tranches, you need a tranche to take the residual flows. Someone has to get the last dollar. Given uncertain cash flows, that last dollar is typically not ratable. That is, the probability that it will be delivered is not high enough to qualify for any fixed-income rating. I suppose you could get a C- or D on it in some cases, but "unrated" sounds better than that. It's really an equity-type risk, not a fixed-income risk.You could deliver the last dollar as a contingent payment to a rated tranche, but you won't get much value in return. People who want rated securities tend to judge them on the promised cash flows, not the contingent ones. This is less true as you move down the ratings ladder, so you could try to add the residual to the lowest rated piece. But in almost all cases, the residual is broken out and either kept by the issuer or sold as an unrated security.

Excellent feedback -- thank you! Do you have an example CDO model (in excel) you wouldn't mind me reviewing?

No, I don't work with CDO's day to day. It's easy enough to reconstruct one from generic terms, or look for details on Bloomberg.