Subordination is a structural feature that ranks different tranches of debt securities in order of priority of payment. This means that in the event of a default, the losses will be allocated to the tranches in the order of their seniority.
The most senior tranche is typically referred to as the "senior debt" or "senior notes". This tranche has the highest priority of payment and will be repaid in full before any other tranches. The subordinated tranches, on the other hand, have a lower priority of payment and will only be repaid after the senior debt has been repaid in full.
Subordination is used in securitisations to provide additional credit enhancement. This means that it helps to reduce the risk of default on the securitisation by absorbing some of the losses in the event of a default.
subordination is sometimes referred to as "credit tranching".
Here are some of the applications of subordination in securitisation:
- To provide credit enhancement: As mentioned above, subordination can be used to provide additional credit enhancement to a securitisation. This can make the securitisation more attractive to investors and can help to reduce the cost of borrowing for the issuer.
- To attract investors with a different risk appetite: Subordinated tranches typically offer higher yields than senior tranches. This is because they are riskier, as they have a lower priority of payment. Investors who are willing to accept higher risk in exchange for higher returns may be attracted to subordinated tranches.
- To align the interests of investors and borrowers: Subordination can help to align the interests of investors and borrowers in a securitisation. This is because subordinated debt holders are more likely to suffer losses in the event of a default. This can encourage borrowers to manage their risk more carefully and to make their payments on time.