What Is a B-Note?
Asset-Backed Securities are broken into various tranches or classes, each of which offer an alternate 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 bore down a bit further, a commercial mortgage-backed security (CMBS) is broken into tranches of notes in the same ABC structure. Each tranche has an alternate level of credit quality and subsequently an alternate priority of payment. A B-note is the secondary tranche in a CMBS loan structure.
How a B-Note Works
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 utilized to make payments to the holders of the security.
As long as the borrower is paying the mortgage on time (at the end of the day, as long as the loan is performing), investors in all tranches will receive their respective shares of the borrower's payments concurrently. Assuming the borrower defaults, that is the point at which the various 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.
Risk Reward of a B-Note
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 feature 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, a large portion of the losses are hence 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 tries to regulate various areas of the financial industry in order to avoid such a crisis again.
For CMBS and B-notes, the regulation came as risk retention obligations under Section 15G of the Securities and Exchange Act of 1934. A portion of the B-note requirements include:
- All B-note investors are equal, meaning that nor investor's losses are subordinate to that of another investor.
- B-note investors must hold on to the B-note investment for at least five years, at which point the investors may just sell their piece to other B-note investors.
- A B-note is a component of ABC financing and the secondary tranche in a commercial mortgage-backed security.
- 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.