The protected tranche's schedule under both repayment clauses, the investor's IRR by call date and the extra margin the bank pays, on one fictional synthetic securitisation.
Under pro rata amortisation the protected tranche repays in step with the reference portfolio; under sequential amortisation it repays only after the senior. On the fictional Northwall 2026-1, the 266.0 million tranche bought by a credit fund returns 10.39 per cent pro rata over five years and 10.49 per cent sequential, 10 basis points more, because the same losses fall on a balance that does not shrink, and the bank keeps paying the 10.50 per cent margin on it: 6.0 million more over five years, 18.6 million over seven. Losses are identical in both cases. Only the timing of principal changes.
Worked in full in Significant Risk Transfer by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
In a synthetic securitisation the bank buys protection on a junior tranche of a loan portfolio and pays the investor a coupon on the outstanding notional. When the loans start to repay, the term sheet has to say whose notional goes down. Pro rata keeps the structure proportional: the protected tranche amortises at the same rate as the pool, so its thickness stays roughly constant. Sequential applies all repayments to the senior first, so the protected tranche keeps its size while the pool shrinks under it, and its thickness as a share of the pool grows.
Nothing about the losses changes. They are a property of the portfolio, not of the repayment clause. What changes is how long the investor's capital is at work earning the margin, how large a balance the same losses are spread over, and how much protection the bank is paying for relative to what it still needs. With a fixed coupon, the investor's IRR is roughly the coupon less the losses as a share of the average balance, so the larger sequential balance dilutes the same losses.
| Input | Value |
|---|---|
| Reference portfolio | 4,000 |
| Protected tranche, 0 to 7.00%, 95% sold | 266.0 |
| Margin over the reference rate | 10.50% |
| Reference rate earned on the collateral | 2.50% |
| Coupon to the investor | 13.00% |
| Replenishment period, years (pool flat) | 2 |
| Pool amortisation a year after that | 8% |
| Best-estimate loss rate a year, on the pool | 0.182% |
| Call, end of year | 5 |
Each year has the same four lines: coupon on the opening balance, write-down for the year's losses, principal repaid, closing balance.
Coupon = 13.00% × opening balance
Write-down = 0.182% × pool × 95%
Pro rata: principal = (opening − write-down) × 8% once the pool amortises
Sequential: principal = 0 until the call, then everything left
Return = IRR of (−266.0, coupon + principal in each year). Excel: =IRR(range)
In years one and two the pool is replenished and the schedules are identical. From year three they part.
| Year | Pool | Opening, pro rata | Repaid, pro rata | Opening, sequential | Repaid, sequential | Write-down, both |
|---|---|---|---|---|---|---|
| 1 | 4,000.0 | 266.0 | 0.0 | 266.0 | 0.0 | 6.9 |
| 2 | 4,000.0 | 259.1 | 0.0 | 259.1 | 0.0 | 6.9 |
| 3 | 3,680.0 | 252.1 | 19.7 | 252.1 | 0.0 | 6.4 |
| 4 | 3,385.6 | 226.1 | 17.6 | 245.8 | 0.0 | 5.9 |
| 5 | 3,114.8 | 202.6 | 197.2 | 239.9 | 234.5 | 5.4 |
| Total | 234.5 | 234.5 | 31.5 |
Principal plus write-downs is 266.0 in both cases. The coupons are not: 156.8 pro rata and 164.2 sequential, because the sequential balance averages 252.6 over the five years against 241.2.
| Call, year | IRR, pro rata | IRR, sequential | Difference, bp | Extra margin paid by the bank | After 25% tax |
|---|---|---|---|---|---|
| 3 | 10.40% | 10.40% | 0 | 0.0 | 0.0 |
| 5 | 10.39% | 10.49% | 10 | 6.0 | 4.5 |
| 7 | 10.36% | 10.58% | 22 | 18.6 | 14.0 |
| 8 | 10.35% | 10.62% | 27 | 27.0 | 20.2 |
The extra cost to the bank is the margin only, 80.77 per cent of the coupon, because the collateral the fund posted earns the reference rate back. Two patterns matter. First, the gap grows with time: called at the end of the replenishment period, the clause is irrelevant. Second, the directions differ. Two extra years cost the pro rata investor 3 basis points of return and add 9 to the sequential one, so a fund holding sequential paper wants the bank not to call, while the bank paying for it wants to call early.
The extra margin is not wasted. Under pro rata the closing balance falls from 6.48 to 5.99 per cent of the pool by year four; under sequential it rises to 7.09 per cent. The bank keeps a thicker first-loss cushion exactly when the pool is smaller and the remaining loans may be the weaker ones, since the better credits tend to refinance first. Whether that cushion earns more capital relief depends on recomputing the senior’s weight at its new attachment point. Northwall’s senior reaches the 15 per cent SEC-IRBA floor only at a 9.74 per cent attachment, as shown in how to calculate the SEC-IRBA risk weight, so part of the extra thickness is rewarded in capital; the bank pays the full margin on all of it.
Many transactions split the difference: pro rata while the portfolio performs, switching to sequential if cumulative losses or a concentration measure breach a trigger. Price such a structure as pro rata in the base case and sequential in the stress case.
The common mistake is to compare offers on margin alone. A sequential deal at 10.50 per cent costs the bank more than a pro rata deal at the same margin, 4.5 after tax over five years here, and the gap triples if the call is not exercised until year seven. The fund's side of the same mistake is to model sequential paper to a five-year call and price the extension risk at nothing. The schedules, the holding-period table and the levered returns are live in the free workbooks for Northwall 2026-1; the return itself is built line by line in how to calculate the return on an SRT tranche.
Because the same losses are spread over a larger balance that stays at work at the full margin for longer. Losses and total principal are the same; only the timing of repayment changes. On Northwall the balance averages 252.6 million over five years sequentially against 241.2 million pro rata, coupons are 164.2 million against 156.8 million, and the IRR rises from 10.39 to 10.49 per cent.
Usually pro rata, because the protection shrinks with the pool and the bank stops paying for cushion it no longer needs, often with a trigger that switches to sequential if losses rise. Sequential costs the bank 6.0 million more margin to a five-year call on Northwall, 4.5 million after 25 per cent tax, in exchange for a cushion that grows from 6.48 to 7.09 per cent of the pool by year four.
Yes. Under pro rata, two extra years move the investor's return by 3 basis points, from 10.39 to 10.36 per cent. Under sequential they add 9, from 10.49 to 10.58, and the bank's extra margin bill grows from 6.0 million to 18.6 million. A fund should price the extension, and a bank should price the call with the clause.
This article is one calculation from Significant Risk Transfer. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: credit, private credit and distressed debt → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.