Loading the player...

What are 'Tranches'

Tranches are pieces, portions or slices of debt or structured financing. Each portion, or tranche, is one of several related securities offered at the same time but with different risks, rewards and maturities. For example, a collateralized mortgage obligation CMO offering a partitioned mortgage-backed securities MBS portfolio might have mortgage tranches with one-year, two-year, five-year and 20-year maturities, all with varying degrees of risk and returns.

BREAKING DOWN 'Tranches'

A tranche is a common financial structure for debt securities such as mortgage-backed securities. These types of securities are made up of multiple mortgage pools that have a wide variety of mortgages, from safe loans with lower interest rates to risky loans with higher rates. Each specific mortgage pool also 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. If an investor wants to invest in an MBO, he can choose the tranche type most applicable to his risk aversion and desired return.

The Theory Behind Mortgage-Backed Securities

All MBOs derive value from underlying mortgage pools and the mortgages within each pool. Investors who invest in an MBO 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 MBO. Investors receive monthly cash flow based on the MBO tranche they invested in.

Benefits and Drawbacks of Tranches

The tranches of an MBO normally coincide with the maturity dates of the underlying mortgages. Other factors like risk sometimes go into the separation of MBOs into tranches. However, the housing market crash forced more stringent mortgage regulations and some believe that there isn't a need for risk-based tranches anymore.

A single tranche will be made up of a pool of mortgages with similar or the same dates of maturity. Investors who desire to have long-term steady cash flow will invest in tranches with a longer time to maturity. Investors who want short-term income that is comparatively higher will invest in tranches with a shorter time to maturity.

All tranches, regardless of interest and maturity, allow investors to customize investment strategies to their specific needs. Conversely, tranches help banks and other financial institutions attract investors across many different profile types. Investors run the risk, however, of investing in the wrong tranche and missing their investment goals. Tranches add to the complexity of debt investing and it sometimes poses a problem to uninformed investors. Further, tranches are sometimes given a higher rating than deserved, causing investors to invest in riskier assets than they expect.

RELATED TERMS
  1. Sequential Pay CMO

    A type of collateralized mortgage obligation (CMO) in which there ...
  2. Active Tranche

    A tranche of a collateralized mortgage obligation (CMO) that ...
  3. Pro-Rata Tranche

    A portion of a syndicated loan that is made up of a revolving ...
  4. Collateralized Loan Obligation ...

    A security backed by a pool of debt, often low-rated corporate ...
  5. Asset-Backed Security - ABS

    A financial security backed by a loan, lease or receivables against ...
  6. Credit Tranche

    A system used by the International Monetary Fund (IMF) to govern ...
Related Articles
  1. Investing

    CMO vs CDO: Same Outside, Different Inside

    The concept of collateralizing and structured financing predates the market for collateralized mortgage obligations and collateralized debt obligations.
  2. Personal Finance

    Profit From Mortgage Debt With MBS

    Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
  3. Investing

    Understanding Collateralized Mortgage Obligations

    A collateralized mortgage obligation (CMO) is a security consisting of a pool of mortgages organized by maturity and risk.
  4. Investing

    What is Securitization?

    Securitization is the process of converting an asset, or group of assets, into a marketable security. Often times, the securitized assets are divided into different layers, or tranches, tailored ...
  5. Personal Finance

    Behind the Scenes of Your Mortgage

    Four major players slice and dice your mortgage in the secondary market.
  6. Personal Finance

    How To Become a Mortgage-Backed Securities Analyst

    Specializing in structured or derivative credit products like mortgage-backed securities requires education and prior experience in the mortgage field.
  7. Investing

    Valeant Announces New Debt Offering

    Valeant is offering new debt securities to repay some outstanding ones. Is it just buying itself more time?
  8. Financial Advisor

    Collateralized Debt Obligations: From Boon To Burden

    CDOs were to be Wall Street's boon - instead they went bust. Find out what went wrong.
  9. Investing

    What is a Collateralized Loan Obligation?

    A collateralized loan obligation (CLO) is a security consisting of a pool of loans organized by maturity and risk.
RELATED FAQS
  1. What is a tranche?

    "Tranche" is actually a French word meaning "slice" or "portion". In the world of investing, it is used to describe a security ... Read Answer >>
  2. Who bears the risk of bad debts in securitization?

    Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, ... Read Answer >>
  3. What is a Z bond in a collateralized mortgage obligation (CMO)?

    Learn about Z-bonds, which are the riskiest level of tranches in collateralized mortgage obligations, and understand how ... Read Answer >>
  4. What's the difference between a collateralized debt obligation (CDO) and a collateralized ...

    Find out how a collateralized mortgage obligation (CMO) is similar to a collateralized debt obligation (CDO), as well as ... Read Answer >>
  5. What's the difference between a collateralized mortgage obligation (CMO) and a mortgage-backed ...

    Find out more about collateralized mortgage obligations and mortgage-backed securities and the difference between the two ... Read Answer >>
Hot Definitions
  1. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  2. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
  3. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities ...
  4. Wash-Sale Rule

    An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security ...
  5. Porter Diamond

    A model that attempts to explain the competitive advantage some nations or groups have due to certain factors available to ...
  6. Oligopoly

    A market structure in which a small number of firms has the large majority of market share. An oligopoly is similar to a ...
Trading Center