"Tranche" is a French word meaning "slice" or "portion." In the world of investing, it is used to describe a security that can be split up into smaller pieces and subsequently sold to investors. Tranches are common with mortgage-backed securities (MBS), which are a basket of mortgage loans that are pooled together for investors to buy.
- Tranches are a collection of securities that are separated and grouped based on various characteristics and sold to investors.
- Tranches can have different maturities, credit ratings, and yields–or interest rates.
- Tranches are common with mortgage-backed securities, which are a basket of mortgage loans that are pooled together for investors to buy.
What Are Tranches?
How Tranches Work
Tranches are a collection of securities that are separated and grouped based on various characteristics and sold to investors. Tranches can have different maturities, credit ratings, and yields–or interest rates. A credit rating is an assessment of the creditworthiness of the borrower or issuer of a particular debt or financial obligation.
The financial instruments that can be broken up into tranches include loans, bonds, mortgages, and insurance policies. Tranches are typically used in the credit and debt markets in a process called securitization, which divides up various types of debt instruments and packaged into funds to be sold to investors who want to earn the interest rate on the debt. Investment bankers can create a single basket of loans that have similar characteristics that appeal to specific investors.
For example, several baskets of loans could be offered that have varying interest rates. Investors who want to earn a 6% yield could opt for that particular tranche of loans (see below) while other investors could opt for the tranche that pays a 3.5% yield.
It's important to note that with any financial product if you get something, you usually have to give something up. In the example above, each yield would likely come with its own specific maturity date and credit rating, which is a measurement of the risk of investing in those loans.
As a result, the basket of loans yielding 6% per year would likely have a longer maturity date or a higher risk of default versus the lower-yielding investments. In other words, investors would demand to be adequately compensated–a higher yield–for holding the investment longer or for taking on more risk than the lower-rate investments.
Not only do tranches of debt instruments have different credit ratings, but they can also have different payout scenarios if the issuer goes into default. Senior tranches, for example, typically have higher credit ratings and are paid before junior tranches in the event of the issuer's bankruptcy or liquidation.
Tranches in the Mortgage Market
Mortgage-backed securities (MBS), such as collateralized mortgage obligations (CMOs), can often be found in the form of a tranche. These securities can be partitioned based on their maturities and credit ratings to appeal to different buyers.
A mortgage-backed security is an investment vehicle that contains a basket of mortgages that are pooled together for investors to buy. A mortgage-backed security is similar to a bond in the sense that it pays an interest rate. However, the rate paid from a bond is typically based on one debt instrument.
A mortgage-backed security, on the other hand, pays a rate based on the interest rates of a collection of home loans in the fund–minus any fees or cost to operate the fund. A mortgage-backed security is an asset-backed security, meaning it is only as safe as the assets backing the loans.
Depending on an investor's preference, a tranche of home loans could be purchased via an MBS that match the investor's desired time period, interest rate, and risk tolerance.
Example of Tranches
For example, investors with various needs could invest in different tranches of the same collateralized mortgage obligation or mortgage-backed security. Let's say that we have four investors who want a similar mortgage-backed security but with different maturity dates.
The portfolio could be split into tranches based on the maturity dates so that there would be tranches maturing in one year, five years, and 20 years. The investor who doesn't need access to cash anytime soon could invest in the 20-year tranche.
However, the investors that are in retirement need the cash in the short-term and opt for the one-year and two-year maturities. The investor that's in pre-retirement, meaning it's only five years away, opts for the tranche with the five-year maturity.
Tranches allow investors to structure their investment earnings and income to match their cash flow needs. Investors who need the cash sooner could buy a shorter maturity investment while those who have a longer time horizon can invest in the longer-maturity tranches. Although investments can be broken up into tranches based on maturity and interest rates, they can also be grouped by domestic and international investments.