Credit Risk Management Practice Exam

What is the primary characteristic of senior tranches in securitization?

1. They are the riskiest and highest yielding bonds

2. They are the largest, safest, lowest yielding bonds

3. They typically have the first claim on cash flows

4. They always have a higher credit rating than mezzanine tranches

The correct answer is: They are the largest, safest, lowest yielding bonds

The primary characteristic of senior tranches in securitization is that they typically have the first claim on cash flows. This means that senior tranche investors are paid before other tranches, such as mezzanine and junior tranches, in the event of payments being distributed from the underlying asset pool. This priority in the cash flow structure significantly reduces the risk for these investors, allowing them to capture returns with a higher degree of safety compared to those holding lower-ranking tranches. While senior tranches can be considered larger and safer compared to their subordinate counterparts, it is important to understand that they also tend to yield lower returns in relation to the risk taken since they are structured to absorb losses last. This prioritization of cash flows establishes senior tranches as a more secure investment option, but not necessarily the highest earning in terms of yield.