Asset-Backed Securities are broken into different tranches or classes, each of which offer a different risk profile and rate of return. The tranches are typically broken into Class A, B, and C.
A mortgage-backed security (MBS), which is a type of asset backed security, has the same structure. To drill down a bit further, a commercial mortgage-backed security (CMBS) is broken into tranches of notes in the same ABC structure. Each tranche has a different level of credit quality and therefore a different priority of payment. A B-note is the secondary tranche in a CMBS loan structure.
B-notes carry higher risk and higher returns when compared to the investment-grade A-note tranche.
In a default, investors of B-notes are paid after the investors of A-notes and before the investors of C-notes.
A lender, typically a bank, originates a secured loan. This secured loan is split into senior and junior pieces, which become the A-note and B-note tranches. Loan payments on the mortgages contained in the overall securitized product are used to make payments to the holders of the security.
As long as the borrower is paying the mortgage on time (in other words, as long as the loan is performing), investors in all tranches will receive their respective shares of the borrower’s payments concurrently. If the borrower defaults, that is when the different tranches come into play. Holders of class A notes are paid their interest and principal payments before holders of class B-notes. As such, this causes B-notes to carry more risk.
To compensate for the higher level of risk, B-notes pay higher interest rates and so make larger payments to the investor than the comparable A-note. A B-note is also assigned a lower credit rating than the corresponding class A-note, which is usually rated investment grade. It is important to highlight that in a default, all of the holders of the A-note must be paid out before any B-note holder can start to be paid. Following the flow, carriers of B-notes are paid before investors of C-notes. In this manner, most of the losses are therefore incurred by the C-note and B-note holders.
After the financial crisis of 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed. The act is a large body of regulation that seeks to regulate various areas of the financial industry so as to avoid such a crisis again.
For CMBS and B-notes, the regulation came in the form of risk retention obligations under Section 15G of the Securities and Exchange Act of 1934. Some of the B-note requirements include:
All B-note investors are equal, meaning that neither investor’s losses are subordinate to that of another investor.
B-note investors must hold on to the B-note investment for a minimum of five years, at which point the investors may only sell their piece to other B-note investors.