Investments, tenth edition

Senior-Subordinated

Tranche Structure

Typical Terms

70–90% of notional

principal, coupon similar to

Aa-Aaa rated bonds

5–15% of principal,

investment-grade rating

5–15% of principal, higher-

quality junk rating

<2%, unrated, coupon rate

with 20% credit spread

Mezzanine 1

Mezzanine 2

Equity/first loss/

residual tranche

 Figure 14.13 

Collateralized debt obligations  

such as mortgage loans or credit card debt. These loans are first pooled together and then 

split into a series of classes known as  tranches.   ( Tranche  is the French word for “slice.”)

 

 Each tranche is given a different level of seniority in terms of its claims on the underlying 

loan pool, and each can be sold as a stand-alone security. As the loans in the underlying pool 

make their interest payments, the proceeds are distributed to pay interest to each tranche in 

order of seniority. This priority structure implies that each tranche has a different exposure 

to credit risk. 

  Figure 14.13  illustrates a typical setup. The senior tranche is on top. Its investors may 

account for perhaps 80% of the principal of the entire pool. But it has first claim on  all   the 

debt service. Using our numbers, even if 20% of the debt pool defaults, the senior tranche 

can be paid in full. Once the highest seniority tranche is paid off, the next-lower class (e.g., 

the mezzanine 1 tranche in  Figure 14.13 ) receives the proceeds from the pool of loans until 

its claims also are satisfied. Using junior tranches to insulate senior tranches from credit 

risk in this manner, one can create Aaa-rated bonds even from a junk-bond portfolio.  

 Of course, shielding senior tranches from default risk means that the risk is concen-

trated on the lower tranches. The bottom tranche—called alternatively the equity, first-loss, 

or residual tranche—has last call on payments from the pool of loans, or, put differently, is 

at the head of the line in terms of absorbing default or delinquency risk. 

 Not surprisingly, investors in tranches with the greatest exposure to credit risk demand 

the highest coupon rates. Therefore, while the lower mezzanine and equity tranches bear 

the most risk, they will provide the highest returns if credit experience turns out favorably. 

 Mortgage-backed CDOs were an investment disaster in 2007–2009. These were CDOs 

formed by pooling subprime mortgage loans made to individuals whose credit standing did 

not allow them to qualify for conventional mortgages. When home prices stalled in 2007 

and interest rates on these typically adjustable-rate loans reset to market levels, mortgage 

delinquencies and home foreclosures soared, and investors in these securities lost billions 

of dollars. Even investors in highly rated tranches experienced large losses. 

 Not surprisingly, the rating agencies that had certified these tranches as investment-

grade came under considerable fire. Questions were raised concerning conflicts of inter-

est: Because the rating agencies are paid by bond issuers, the agencies were accused of 

responding to pressure to ease their standards.     

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