# Dual Tranche Model

### **Two Tranches**

The dual tranche system at the heart of Pencil Finance allows for structured capital deployment and clearly separated risk exposure. Inspired by traditional structured finance products such as collateralized debt obligations (CDOs), this model has been redesigned for transparency and programmability on-chain.

Each student loan bundle is split into two capital tranches:

* **Senior Tranche (80%)** – Backed by the Grow Token (ERC-20), this tranche is designed for conservative investors seeking predictable returns. It earns a fixed interest rate set by the lending partner at the time of bundle creation. Senior tranche investors are repaid first, both in terms of principal and interest.
* **Junior Tranche (20%)** – Represented by the EDUFI NFT (ERC-721), this tranche takes on more risk in exchange for a higher potential yield. The interest rate is variable and depends on actual bundle performance. Junior tranche investors receive interest distributions more frequently (monthly or quarterly) and are only repaid principal after all senior obligations have been fulfilled.

### **Repayment Waterfall Model**

All repayments from the lending partner follow a fixed distribution sequence designed to protect senior capital first and align junior returns with real loan performance:

1. **Senior Principal** – Repaid first to preserve capital for low-risk investors.
2. **Senior Interest** – Paid after principal and reflected through an increase in the NAV of Grow Tokens.
3. **Junior Principal** – Repaid only after all Senior obligations (principal and interest) are fully covered. This ensures that the Junior tranche only receives capital back if the loan bundle performs well.
4. **Junior Interest** – Any remaining repayment amount is distributed as interest to Junior tranche NFT holders on a monthly or quarterly basis, as per bundle configuration.

This structure prioritizes principal protection for conservative investors and shifts the performance risk toward junior investors, who in turn benefit from higher yield potential. It creates a robust and transparent repayment model that reinforces accountability from lending partners and sustainable returns for investors.

### **Loss Absorption**

In the event of borrower defaults or missed repayments:

* **Junior Tranche absorbs the first losses**. If loan repayments fall short, these losses reduce the Junior investor’s expected return before touching the Senior Pool.
* The Senior Tranche remains protected unless the Junior capital is entirely depleted.

This loss structure incentivizes responsible bundle creation by lending partners (who often subscribe to the Junior Tranche themselves) and aligns the protocol with traditional credit risk frameworks.

By combining two investment instruments with distinct risk-return dynamics, Pencil Finance enables diversified participation while ensuring transparency and resilience in loan repayment handling.

<figure><img src="/files/NFuPwELk1B7pGJUcolUY" alt=""><figcaption><p>Waterfall Model</p></figcaption></figure>


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