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Internal credit enhancements are common for securitizations called subordination (or credit tranching). Note that a tranche is the French word for “slice,” so tranches are simply different slices of the same security.
There could be more than one bond class (or tranche), and bond classes vary depending on how they will share any losses resulting from borrowers’ defaults (or prepayment, which we will see later). Bond classes can be categorised as senior tranches or subordinated (junior) tranches. Losses are first absorbed by the most junior (lower) classes. In addition, more than one subordinated bond class could be created as shown in the structure below.
$$
\begin{array}{c|c}
\textbf{Bond Class} & \textbf{Par value (in US\$ million)} \\
\hline
\text{A (Senior)} & \text{90} \\
\text{B (Subordinated)} & \text{6} \\
\text{C (Subordinated)} & \text{4} \\
\text{Total} & \text{100} \\
\end{array}
$$
In this simple structure, all losses on the collateral are first absorbed by Class C, before any losses are absorbed by Class B, and then Class A. If the losses do not exceed $4 million, Class B will not suffer any losses. Similarly, Bond Class A would only suffer a loss if the total loss exceeds $10 million.
Time tranching is the process of classifying bonds that possess different maturities. It creates a series of bonds with different average lives and durations to match investors’ liquidity needs.
Note that some asset-backed security structures can have both credit tranching and time tranching.
Credit ratings are assigned to each of the various bond classes. Each credit rating depends on the quality of the collateral and its seniority in the waterfall structure. Some of the bond classes could even have a better credit rating than the parent company – the financial institution originating the loans. The total funding cost could be lower for the financial institution than a corporate bond issue to finance the same project.
The key reason for cheaper financing costs is that SPEs would not be affected by the parent company’s bankruptcy. The only rule is that senior creditors are paid in full before subordinated creditors are paid anything.
Question
A UK-based SPE has issued asset-backed securities with the following structure.
$$
\begin{array}{c|c}
\textbf{Bond Class} & \textbf{Par value (in US\$ million)} \\
\hline
\text{A (Senior)} & \text{145} \\
\text{B (Subordinated)} & \text{35} \\
\text{C (Subordinated)} & \text{50} \\
\text{Total} & \text{230} \\
\end{array}
$$Which of the following minimum amount of losses would hurt Bond Class A holders?
- GBP 35 million.
- GBP 56 million.
- GBP 85 million.
Solution
The correct answer is C.
The first GBP 85 million (50+35) in default would be absorbed by subordinated classes. As such, the senior Class A bonds would only experience losses if defaults are larger than GBP 85 million.