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.