Subordination Analysis
Definition
Subordination measures the percentage of CLO capital structure junior to a specific tranche, creating loss absorption capacity that determines tranche ratings and risk profiles. A AAA tranche at 60% of capital structure has 40% subordination—meaning 40% of losses must occur before AAA faces principal impairment. Subordination combines with excess spread (interest cushion) to determine break-even default rates. Standard CLO structures allocate: 60-65% AAA, 8-10% AA, 5-7% A, 3-5% BBB, 2-4% BB, 7-10% equity. This waterfall ensures sequential loss absorption—equity absorbs first dollar of losses, then BB, then BBB, working up the structure. Rating agencies size subordination based on stress-test losses: AAA must withstand severe recession scenarios with minimal impairment.
Why it matters
Subordination directly determines tranche pricing and risk-return profiles. AAA tranches with 40% subordination trade at SOFR+120-140 bps (low risk premium) because portfolio must suffer 40%+ cumulative losses before impairment—far exceeding historical stress default rates. BBB tranches with 18-20% subordination trade at SOFR+400-500 bps reflecting material risk of touching losses during severe stress. Equity with zero subordination (residual claim) targets 15-20% IRRs but faces first-dollar losses. During 2008-2009, realized cumulative losses reached 30-35% in worst vintages—impairing equity, BB, and BBB tranches while AAA remained protected. Understanding subordination stacks explains why CLO equity lost 60-80% NAV while AAA traded at 90 cents (liquidity discount, not fundamental impairment).
Common misconceptions
- •Subordination isn't static—it changes over time as defaults erode equity and junior tranches, increasing effective subordination for senior tranches. AAA starting at 40% subordination might have 50%+ as deal seasons.
- •Thicker subordination doesn't always mean safer tranches—portfolio quality matters. AAA with 40% subordination in high-quality portfolio safer than AAA with 45% subordination in deteriorating portfolio.
- •Rating agencies don't use identical subordination requirements—Moody's, S&P, and Fitch have different stress scenarios leading to different required subordination levels for equivalent ratings.
Technical details
Tranche sizing and capital structure mechanics
Standard CLO structure ($500M collateral): Class A (AAA) $325M (65%), Class B (AA) $45M (9%), Class C (A) $32.5M (6.5%), Class D (BBB) $22.5M (4.5%), Class E (BB) $15M (3%), Subordinated notes/equity $60M (12%). Total leverage = 88%, equity = 12%.
Subordination calculation: Class A subordination = 100% - 65% = 35%. Class B subordination = 100% - 65% - 9% = 26%. Class C = 19.5%. Class D = 15%. Class E = 12%. Equity = 0% (residual claim). Each tranche protected by everything junior.
Effective credit enhancement: Subordination plus excess spread creates total protection. AAA with 35% subordination earning 6% coupon over 10 years has 35% + 60% = 95% total enhancement. Portfolio must experience 95% / 30% loss severity = 317% cumulative defaults to impair AAA (impossible threshold).
Tranche thickness: Class A at 65% represents 'thick' tranche—large par amount provides liquidity and diversifies holders. Mezzanine tranches (3-9% each) are 'thin'—smaller issuance creates liquidity challenges and concentration among holders. Equity at 8-12% represents manager/sponsor alignment risk-sharing.
Rating agency subordination requirements
Moody's subordination benchmarks: AAA requires 32-38% subordination (depending on WARF/diversity), AA requires 23-28%, A requires 17-22%, BBB requires 12-17%, BB requires 8-12%. Ranges reflect portfolio quality variability—higher WARF requires more subordination for equivalent rating.
S&P subordination requirements: Typically 2-4% more conservative than Moody's. AAA requires 35-40%, AA requires 26-31%, A requires 20-24%, BBB requires 15-18%. S&P's cash flow modeling approach captures time-value losses requiring thicker subordination.
Fitch subordination: Falls between Moody's and S&P. AAA requires 33-39%, AA requires 24-29%, A requires 18-23%, BBB requires 13-18%. Uses correlation-adjusted stress scenarios producing intermediate subordination requirements.
Multi-rating arbitrage: CLOs seek ratings from all three agencies to maximize investor base. Must size subordination to satisfy most conservative agency for each tranche. Typically means S&P requirements drive AAA/AA sizing, Moody's diversity drives portfolio construction, Fitch provides confirmation.
Dynamic subordination and portfolio evolution
Subordination accretion: As defaults occur, equity NAV declines but equity % of structure stays constant. Senior subordination increases as junior tranches written down. Example: $60M equity reduced to $40M by losses—AAA subordination rises from 35% to 39% ($40M / ($500M - $60M + $40M)).
Par value vs market value subordination: Subordination calculated on par, not market value. During stress, collateral might trade at 85 cents but subordination uses $500M par. This creates disconnect—market implies higher losses than par-based subordination suggests. Mark-to-market subordination would show less protection.
Amortization effects: During amortization period, sequential pay benefits senior tranches. As Class A pays down, subordination for remaining Class A increases (smaller numerator, denominator shrinking proportionally less). Creates improving credit profile for senior tranches over time.
Defaults vs trading losses: Defaulted loans written down, reducing collateral par and subordination. Trading losses (selling loan at 80 cents) don't affect par-based subordination but reduce actual equity value. This creates scenarios where equity NAV impaired significantly but subordination tests still passing (measured on par).
Stress testing and subordination adequacy
Historical loss experience: 2008-2009 CLO vintages (2005-2007) experienced 30-35% cumulative defaults with 55-60% recovery (18-20% cumulative losses). AA/AAA tranches generally unimpaired. BBB tranches experienced 10-30% principal losses. BB/equity effectively wiped out in worst deals.
Severe stress scenarios: 50% cumulative defaults × 40% loss severity (60% recovery) = 20% portfolio losses. AAA with 35% subordination remains unimpaired (15% cushion). AA with 26% subordination unimpaired (6% cushion). A with 19% subordination faces minimal losses. BBB with 13% subordination experiences 7% principal impairment. BB and equity wiped out.
Subordination vs WARF trade-offs: Rating agencies allow lower subordination if compensated by higher credit quality (lower WARF). Example: Portfolio at 2700 WARF might achieve AAA at 35% subordination, while 2900 WARF requires 38%. Managers optimize this trade-off—tighter subordination allows larger equity base (more fee income) but requires higher-quality collateral.
Correlation impact: Assumed 30-40% asset correlation in agency models. Higher realized correlation during systemic stress (70-80% in 2008-2009) causes more simultaneous defaults than models predict. Effectively reduces subordination protection—35% subordination behaves like 25-28% when correlation spikes. This explains why BBB tranches designed for safety experienced losses.