The capital structure of a collateralized debt obligation (CDO) is made up of three tranches: 1) an equity tranche (also, a first-loss tranche), 2) a mezzanine tranche and 3) a senior tranche. A tranche is a portion (slice) of a pooled collection of securities, e.g., debt instruments, that are divided according to a specific factor (such as risk) in order to make such securities more appealing (i.e., marketable) to potential investors. Tranches have their specific maturities, yields, risk and priority in repayment (seniority) in case of default.

Equity tranche absorbs initial losses (it provides the first level of protection against any defaults) and is by nature the lowest tranche in terms of seniority and priority in repayment. In other words, it represents a claim on all remaining cash flows after having repaid all the obligations for each senior and mezzanine tranches.

Mezzanine tranche (also known as an intermediate risk tranche) is a layer positioned between the senior tranche (lowest risk) and a junior tranche (equity tranche, with highest risk). This tranche absorbs any losses that the equity tranche is unable to absorb until the mezzanine tranche’s principal is also exhausted.

Senior tranche (lowest risk) is made up of the balance of the pool and serves as an absorbent of any residual losses (losses that cannot be absorbed by equity and mezzanine tranches).