What are Tranches
Tranches are pieces of debt or securities designed to divide risk or group characteristics in order to be marketable to different investors. Each portion, or tranche, 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.
BREAKING DOWN 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 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. More senior-rated tranches typically have higher credit ratings than the lower-rated tranches. Examples of financial products that can be divided into tranches include loans, insurance policies, mortgages and other debts.
An Example of Tranches: Mortgage-Backed Securities
A tranche is a common financial structure for debt securities such as a mortgage-backed security (MBS). These types of securities are made 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 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 (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. If an investor wants to invest in mortgage-backed securities, he can choose the tranche type most applicable to his risk aversion and desired return. However, the housing market crash of 2008 forced more stringent mortgage regulations, and some believe that there isn't a need for risk-based tranches anymore.
All mortgage-backed securities derive value from underlying mortgage pools and the mortgages within each pool. Investors who invest in an MBS 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 receive monthly cash flow based on the MBS tranche in which they invested.
Benefits and Drawbacks of Tranches
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. Tranches add to the complexity of debt investing and sometimes pose a problem to uninformed investors, who run the risk of choosing the wrong tranche and missing their investment goals. Tranches are sometimes given a higher rating than deserved, causing investors to invest in riskier assets than they initially thought.