Understanding Tranches

Tranches are segments created from a pool of securities—usually debt instruments such as bonds or mortgages—that are divvied up by risk, time to maturity, or other characteristics in order to be marketable to different investors. Each portion or tranche of a securitized or structured product is one of several related securities offered at the same time, but with varying risks, rewards and maturities to appeal to a diverse range of investors.

They are commonly found in mortgage-backed securities (MBS) or asset-backed securities (ABS).

Tranches are pieces of a pooled collection of securities, usually debt instruments, that are split up by risk or other characteristics in order to be marketable to different investors.

Tranches carry different maturities, yields, and degrees of risk—and privileges in repayment in case of default. Tranches are common in securitized products like CDOs and CMOs.

Tranches in structured finance are a fairly recent development, spurred by the increased use of securitization to divide up sometimes-risky financial products with steady cash flows to then sell these divisions to other investors. The word tranche comes from the French word for slice.

The discrete tranches of a larger asset pool are usually defined in transaction documentation and assigned different classes of notes, each with a different bond credit rating.

Senior tranches typically contain assets with higher credit ratings than junior tranches. The senior tranches have first lien on the assets—they’re in line to be repaid first, in case of default. Junior tranches have a second lien or no lien at all.

Examples of financial products that can be divided into tranches include bonds, loans, insurance policies, mortgages and other debts.

A tranche is a common financial structure for securitized debt products, such as a collateralized debt obligation (CDO), which pools together a collection of cash flow-generating assets—such as mortgages, bonds, and loans—or a mortgage-backed security. An MBS is made of multiple mortgage pools that have a wide variety of loans, from safe loans with lower interest rates to risky loans with higher rates. Each specific mortgage pool has its own time to maturity, which factors into the risk and reward benefits. Therefore, tranches are made to divide up the different mortgage profiles into slices that have financial terms suitable for specific investors.

For example, a collateralized mortgage obligation (CMO) offering a partitioned mortgage-backed securities portfolio might have mortgage tranches with one-year, two-year, five-year and 20-year maturities, all with varying yields. If an investor wants to buy a MBS, they can choose the tranche type most applicable to their appetite for return and aversion to risk. A Z tranche is the lowest-ranked tranche of a CMO in terms of seniority. Its owners are not entitled to any coupon payments, receiving no cash flow from underlying mortgages until the more senior tranches are retired, or paid off.

Investors receive monthly cash flow based on the MBS tranche in which they invested. They can either try to sell it and make a quick profit or hold onto it and realize small but long-term gains in the form of interest payments. These monthly payments are bits and pieces of all the interest payments made by homeowners whose mortgage is included in a specific MBS.

Investors who desire to have long-term steady cash flow will invest in tranches with a longer time to maturity. Investors who need a more immediate but a more lucrative income stream will invest in tranches with less time to maturity.

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