Tranche - Explained
What is a Tranche?
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Table of ContentsWhat is a Tranche?How Does a Tranche Work?An Example of Tranches: Mortgage-Backed SecuritiesBenefits and Drawbacks of Tranches
What is a Tranche?
Tranches refer to pieces of securities or debts created to group characteristics or divide risk so as to be marketable to various investors. Each portion or tranche refers to one of the various related securities offered simultaneously but with different risks, maturities, and rewards which can appeal to investors of different types.
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How Does a Tranche Work?
In structured finance, tranches are a fairly recent development. They arose as a result of an increase in the use of securitization for the purpose of dividing sometimes-risky financial products with constant cash flows. These divisions are then sold to other investors. Tranche originated from the French word for slice. Usually, a larger asset pools discrete tranches are defined in transaction documentation and also assigned different note classes, each having a different bond credit rating. Typically, more higher-rated tranches have credit ratings that are higher, unlike the lower-rated ones. Examples of financial products which can be split into tranches include insurance policies, mortgages, loans, and other debts.
An Example of Tranches: Mortgage-Backed Securities
A tranche refers to a common financial structure used for debt securities like mortgage-backed security (MBS). These security types are made of many mortgage pools which have a wide range of mortgages, ranging from safe loans that have lower interests to the risky ones with higher rates. Each mortgage pool has its own maturity time, which results in the risk, as well as, reward benefits. Hence, tranches are made to split the various mortgage profiles into slices which have financial terms which would fit certain investors. For instance, a collateralized mortgage obligation (CMO) that offers a partitioned mortgage-backed securities portfolio may have mortgage tranches with maturities of a year, two years, five years, and even twenty years. They all have various risk and return degrees. In a situation where an investor is interested in investing in mortgage-backed securities, the investor can select the type of tranche most suitable for averting risk and getting desired returns. However, the 2008 housing market crash imposed more strict mortgage regulations, and there are those who believe that there is no need for tranches that are risk-based. All securities that are mortgage-backed derive obtain value from underlying mortgage pools, as well as, the mortgages in each pool. Investors that invest in mortgage-backed security can either attempt selling it and making a quick profit or hold on to it and get small gains that are long-term in the form of interest payments. The monthly payments are small amounts from every interest payment made by homeowners who have their mortgage included in a certain MBS. The MBS tranche in which investors invested determines their monthly cash flow.
Benefits and Drawbacks of Tranches
Investors who wish to have long-term constant cash flow would invest in tranches that have a longer period of maturity. Investors interested in a comparatively higher short-term income would invest in tranches having shorter maturity time. All tranches, irrespective of maturity and interest, allow the customization of investment strategies by investors to suit their needs. Conversely, tranches aid banks, as well as, other financial institutions attract investors with various profiles. Tranches add to debt investing complexity and occasionally constitute a problem to ignorant or uninformed investors who are likely to choose the wrong tranche, thus missing their investment goals. There are certain times when tranches are given ratings higher than they deserve, thereby making investors invest in more risky assets that they initially bargained for.