Tranching is the process of dividing a securitization pool's cash flows into layers (tranches) with different risk, yield, and priority — senior tranches receive payments first and absorb the least risk; equity/junior tranches receive payments last and absorb losses first.
Tranching is the core mechanism of structured finance. A pool of assets (mortgages, loans, receivables) generates uncertain cash flows — some borrowers may default. Tranching reorders those uncertain cash flows into more predictable layers by establishing a payment waterfall: senior investors get paid first from pool collections; subordinate investors get whatever remains after seniors are paid; equity investors absorb losses and receive residual upside. Standard tranche stack in an ABS or CMBS deal: - Senior (AAA–AA): Highest priority claim on cash flows. First to receive principal and interest. Protected by all subordinate tranches as a credit buffer. Typically 70–85% of the deal. Lowest yield. - Mezzanine (A–BBB-): Middle-layer tranches. Receive payments after senior but before subordinate. Moderate credit risk, moderate yield. - Subordinate / B-piece (BB–B): First-loss layer for institutional credit investors. Below investment grade. Take losses before mezzanine and senior. - Equity / Residual: No credit rating. Receive residual cash after all bonds are paid. Absorb first losses dollar-for-dollar. Highest risk, highest potential yield (or total loss). Transitioning between tranches is governed by triggers: performance tests (OC test = overcollateralization; IC test = interest coverage) that, if breached, redirect cash from junior to senior tranches until the test passes. This dynamic protection mechanism is why AAA-rated ABS tranches can maintain their rating even as a portion of the collateral pool defaults. Tranching is also used outside securitization: VC deals tranche equity (liquidation preferences, participation rights) and some construction loans tranche draws by project milestone.
Because the subordinate tranches below the senior act as a credit buffer. If 10% of a pool defaults with 50% recovery (5% net loss), and the deal has 20% subordination below the senior, the senior tranche absorbs zero losses. The rating is based on how large the loss scenario would need to be to impair the senior — not the average expected loss of the pool.
The payment waterfall defines the exact order in which cash collected from pool assets is distributed. Typically: (1) trustee and servicer fees; (2) senior note interest; (3) senior note principal; (4) mezzanine interest; (5) mezzanine principal; (6) subordinate interest/principal; (7) equity/residual. If collections are insufficient, lower-priority recipients receive nothing until higher-priority claims are satisfied.