A-Note

What is an A-Note?

An A-note is the highest tranche of an asset-backed security (ABS) or other structured financial product. During bankruptcy, default, or other credit proceedings, an A-note is senior to other notes, such as B-notes. This senior status allows the payment from the underlying assets of A-note debt before others.

A-notes can be rated, or labeled, into AAA, AA or A categories, depending on the credit quality of the underlying asset. They may also be referred to as a “class A note.”

How an A-Note Works

A-notes are commonly seen in mortgage-backed securities (MBS), although they are an aspect of many other types of structured financial products. These asset-backed securities include those made up of loans, insurance policies and other debts. They are structured so that investments and investors are divided into tranches, each with a different set of risks and rewards.

This layering structure has become more common as banks and other financial institutions have popularized the use of securitization. Through securitization, multiple financial assets, some riskier than others, are combined into one product. That packaged financial product is then divided up into tiers, each with a distinct level of risk. 

Dividing the combined product in this way allows investors to purchase shares of the underlying debt pool as a type of bond. The division into tranches further enables the investors to select the level of risk and reward that best suits their purposes. Investors in A-notes tranches take on less risk, but typically have a lower potential rate of return than holders of B-notes or C-note assets.

Example of an A-Note

For example, an investor might buy an A-note in a mortgage-backed security. As long as the underlying loan is performing, investors in all tranches will receive their interest and principal payments on schedule. However, if the borrower defaults or some other credit proceeding takes place, the investor holding the A-note will be paid back first, before those holding lower tranches of notes. Lower level notes are referred to as subordinate notes. For this reason, A-notes have a higher credit rating than corresponding B-notes or C-notes.

Generally speaking, A-notes have a lower interest rate than B-notes, while B-notes carry a lower interest rate than C-notes, etc. Interest rates and ratings are based on the risk of the debt. Higher interest rates on lower graded debt is there to entice borrowers.

Limitations of an ‘A-Note’

An A-note does offer more credit protection than their subordinate counterparty notes, as investors in A-notes are more likely to receive payment, even in the case of a default or other credit proceeding. However, increased security comes at a price. A-notes typically give smaller returns to the investor than B- or C-notes. To compensate investors of subordinate notes the yields are higher to match the additional risk.

Furthermore, investors in the A-note tranche must still pay attention to the creditworthiness of investments in the subordinate classes. As the risk levels of lower level investments increase, the chances of default and repayment risk rise for all investors.