Waterfall Priority
Definition
The sequential order in which cash flows from a structured credit pool (loans, bonds, receivables) are distributed to various stakeholders. The waterfall establishes strict priority—senior obligations must be fully satisfied before junior obligations receive any payment, creating a hierarchy from AAA debt through equity.
Why it matters
Waterfall priority is the fundamental protection mechanism in structured credit. AAA tranches receive payments first, insulating them from credit losses until subordination is exhausted. Understanding waterfall mechanics explains why senior tranches trade with minimal credit spreads while equity can return 12-15% but face total loss in severe scenarios. Changes to waterfall priority (through amendments, diversion, or test failures) materially impact expected returns across the capital structure.
Technical details
Standard CLO waterfall sequence
Typical CLO payment priority: (1) Trustee and administrative fees, (2) Senior secured expenses and hedge counterparty payments, (3) Class A (AAA) interest, (4) Class B (AA) interest, (5) Class C (A) interest, (6) Class D (BBB) interest, (7) Class E (BB) interest (subordinated debt), (8) Coverage test compliance verification, (9) If tests pass: equity distributions or reinvestment in new assets, (10) If tests fail: cash flow diversion to pay down senior principal. Within each level, payment is typically pro-rata among that class. Exact priority and class structure varies by deal.
Principal vs interest waterfalls
Most structures have separate waterfalls for interest proceeds and principal proceeds. Interest waterfall: follows the sequence above (fees → AAA interest → AA interest → equity). Principal waterfall during amortization: pays down debt tranches sequentially (AAA paid in full, then AA, then A, etc.). Principal during reinvestment period: manager can reinvest in new assets rather than paying down debt (if tests pass). This split creates scenarios where equity receives interest distributions while principal is trapped in senior debt paydown.