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For example, senior tranches may be rated AAA, AA or A, while a junior, unsecured tranche may be rated BB. However, ratings can fluctuate after the debt is issued, and even senior tranches could be rated below investment grade (less than BBB).
Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in high-quality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that is a few basis points below ...
For example, a $100mm PAC tranche off 6% collateral with a 6% coupon ('6 off 6' or '6-squared') can be cut into a $100mm PAC tranche with a 5% coupon (and hence a lower dollar price) called a '5 off 6', and a PAC IO tranche with a notional principal of $16.666667mm and paying a 6% coupon.
Hence, after the first default in the portfolio, the equity notes, i.e.; Class D notes in the above example are reduced to $24,000,000 from $30,000,000. A typical single-tranche CDO is a note issued by a bank or an SPV where in addition to the credit risk of the issuing entity, the investors take credit risk on a portfolio of entities. In ...
For a second example of subordinated debt, consider asset-backed securities. These are often issued in tranches. The senior tranches get paid back first; the subordinated tranches later. A third example is mezzanine debt.
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The senior/subordinated structure thus consists of several tranches, from the most senior to the most subordinated (or junior). The subordinated tranches function as protective layers of the more senior tranches. The tranche with the highest seniority has the first right on cash flow. Such protection comes under a waterfall structure.
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