What Are Tranches?
Tranches are segments created from a pool of securities—usually debt instruments such as bonds or mortgages—that are divided up by risk, time to maturity, or other characteristics to appeal to different investors. Each tranche in a securitized or structured product is offered at the same time but comes with varying risks, rewards, and maturities to appeal to a diverse range of investors.
Tranche is a French word meaning slice or portion. They are commonly found in mortgage-backed securities (MBS) or asset-backed securities (ABS).
Key Takeaways
- Tranches are pieces of a pooled collection of securities, usually debt instruments, split up by risk characteristics to market them 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.
Understanding Tranches
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. The discrete tranches of a larger asset pool are typically defined in transaction documentation and are assigned different classes of notes, each with its 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.
Tranches in Mortgage-Backed Securities
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 composed of multiple mortgage pools with various loans, ranging from safe ones with lower interest rates to risky ones with higher rates. Each mortgage pool has its time to maturity, contributing to its risk and reward profile. Therefore, tranches are employed to divide different mortgage profiles into slices that have financial terms suitable for specific investors.
For example, a collateralized mortgage obligation (CMO) may have mortgage tranches with one-year, two-year, five-year, and 20-year maturities, all with varying yields. Investors can choose the tranche type that fits their risk-return profile.
Investment Strategy in Choosing Tranches
Investors seeking long-term steady cash flow will invest in tranches with longer maturities. On the other hand, investors looking for more immediate but lucrative income streams will invest in tranches with shorter maturities.
All tranches, regardless of interest and maturity, allow investors to tailor their investment strategies. Conversely, tranches help banks and other financial institutions attract a diverse range of investors.
Tranches can add complexity to debt investing and can sometimes pose problems for uninformed investors, who risk choosing incorrect tranches for their investment goals.
Inevitably, tranches can be miscategorized by credit rating agencies, potentially exposing investors to higher risks than intended. This mislabeling played a significant part in the mortgage meltdown of 2007 and the subsequent financial crisis.
Tranche Lawsuits in the 2007-2009 Financial Crisis
Following the financial crisis of 2007-09, numerous lawsuits were filed against issuers of CMOs and CDOs. An April 2008 story noted that investors in senior tranches were leveraging their priority status to control assets and cut payments to other debt holders.
And in 2009, a hedge fund manager filed a lawsuit against the mortgage-servicing company for allegedly selling foreclosed properties at low prices, thus affecting the yield of the junior tranche.
What Are the Three Types of Tranches?
Generally, pooled financial securities are divided into three tranches: senior, mezzanine, and junior. Each tranche has a different level of risk and therefore, a different level of return. Senior tranches have the least risk and the lowest returns, while junior tranches have the highest risk and the highest returns. Mezzanine tranches sit between the two.
What Is an Example of a Tranche?
Suppose hundreds of mortgages are pooled into a security—like a mortgage-backed security (MBS). The mortgages have different credit profiles based on the holder of the mortgage. For instance, some borrowers may have excellent credit profiles and thus secure mortgages with low-interest rates, while others have subpar credit profiles with higher interest rates. These different mortgages get divided into various tranches. The low-risk mortgages go into the senior tranche, whereas high-risk mortgages go into the junior tranche. Investors decide which tranche to invest in based on their risk tolerance.
Is a CMO a CDO?
A collateralized mortgage obligation (CMO) is a type of collateralized debt obligation (CDO), but it is constructed of underlying mortgages. CDOs are pooled investment securities comprising various fixed-income assets but are typically made up of loans. CMOs specifically entail CDOs where the loans are mortgages.
What Is a AAA Tranche?
Most pooled fixed-income investments consist of tranches assigned a credit rating. AAA-rated tranches are of the highest quality, meaning they are the least risky but also offer the lowest returns. Sometimes large projects or sovereign governments may require large amounts of funding, and banks may collaborate to offer such funds and create pro-rata tranches, which also have assigned credit ratings.
The Bottom Line
Tranches allow investors to choose their level of risk and return when investing in pooled securities. Those seeking higher returns might opt for riskier tranches, such as those containing below-investment-grade securities. Meanwhile, those seeking safer returns will prefer investment-grade tranches.
References
- Financial Times. "‘Tranche Warfare’ Breaks Out Over CDOs".
- Superior Court of Connecticut. “Carrington Asset Holding Company, LLC et al. v. American Home Mortgage Servicing, Inc”.
