Tranche is a French word meaning slice or portion. They are found in mortgage-backed securities (MBS) or asset-backed securities (ABS). Tranches are segments created from a pool of securities—usually debt instruments such as bonds or mortgages—that are divided up by risk, time to maturity, or other characteristics in order to be marketable to different investors.
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What are bond tranches?
Bond tranches are usually portions of mortgage-backed securities that are offered at the same time and that typically carry different risk levels, rewards, and maturities. These securities are made up of multiple mortgage pools that have different mortgage varieties. They can be ranging from safe loans with low-interest rates to risky loans with high interest rates.
How do tranches work?
Tranches are paid sequentially starting from the senior tranches to the junior tranches. Senior tranches have a higher bond credit rating while junior tranches have a low bond rating. These ratings fluctuate once the debt is issued. Tranches with a first lien on underlying assets are referred to as senior tranches and those with a second lien are junior tranches. The first-lien is considered safer to invest in as compared to the second lien as the second lien tranches are unsecured.
Tranches are secured as well as unsecured. Secured tranches are backed by an asset and unsecured ones are not. Tranches can be senior or subordinated. Subordinate debt absorbs losses before senior debt does.
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Benefits of Bond Tranches:
Tranches allow investors to create a single or several classes of securities. Tranches have a higher rating than the underlying asset pool. All the losses are absorbed by the junior tranches and hence the senior tranches are insulated from the risk of default.
Tranches allow investors to customize their investment strategies to their needs. Investors who would like to have a long-term and steady cash flow should invest in tranches with long-term maturity dates and investors who prefer short-term tranches should invest in tranches with short-term maturity dates.
Tranches are complex because they require detailed documentation. Investors should be careful while investing in such structured securities. Tranches are given higher ratings sometimes than they deserve which makes investors invest in more risker bonds than they prefer. The ratings are given based on historical performance rather than on real-time performance.
Tranches are sophisticated financial products that allow investors to choose very specific risk and reward portions. Tranches are low risk and low return. Z-tranches are the riskiest. They only payout once the other tranches are paid.
Individual investors should avoid tranches. They are a synthetic product that has very little relation to their underlying real assets. That makes it difficult to determine whether they are a good value. They are very complicated. It’s difficult to know whether they meet investors’ asset allocation and diversification goals.
Author: Saachi Lodha
About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.