Lesson 5 of 5 · 14 min
Tranching: who is paid first and who loses first
Tranching splits one pool into senior and subordinated bond classes, so cash is paid from the top down and losses are absorbed from the bottom up.
In short
- Subordination (tranching) creates several bond classes (tranches) with different claims on the same pool.
- Senior tranches are paid first; subordinated (junior, non-senior) tranches such as mezzanine and equity are paid after.
- Losses hit the bottom first: equity, then mezzanine, then senior. This is a senior/subordinated structure.
- More risk → higher promised yield: senior has the highest rating and lowest spread; equity gets whatever cash is left (residual).
- Credit enhancements can be added on top to reduce investors' risk further.
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