Tranches

Definition

Tranches are portions of debt or securities that are categorized into varying degrees of risk and return. They are used in structured finance, and are particularly common in mortgage-backed securities (MBS). Different tranches from the same debt issue can thus have different risk, interest rate, and maturity profiles.

Phonetic

The phonetics of the keyword “Tranches” is /trɑːnʃ/.

Key Takeaways

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1. Tranches are a technique for distributing financial products, particularly investments tied to cash flows, like mortgage-backed securities and collateralized debt securities. These financial instruments are broken down into tranches (French for ‘slices’) based on risk level, return, and maturity.
2. Lower-risk tranches are considered senior securities and they have a preferential claim on any cash flows from the underlying portfolio of securities. Higher-risk tranches give investors the opportunity for greater returns, but they also bear the first losses if the underlying securities default.
3. The structure of tranches allows institutions to tailor the parts to meet investor demand, and to price at a yield and rating level that will satisfy investors. This process often involves underwriting and credit enhancement. Investors can choose the tranche that best suits their risk tolerance and return requirements.

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Importance

Tranches are important in business/finance because they provide a method of diversifying and managing potential risk in investment settings, particularly in areas like structured financing and securitization. The idea of tranche comes from the French word for “slice” and it indicates a portion of a pool of securities, with each tranche having different risk profiles, rewards, maturities, and priorities in the debt repayment stream. Therefore, by separating financial products into tranches, investors can select the product that matches their risk tolerance, reward expectations, and investment time horizon. This flexibility attracts a wide range of investors to the market, enhancing liquidity and contributing to the overall efficiency of financial markets.

Explanation

Tranches are commonly utilised in the world of finance to create a more organized, systematic, and manageable method of breaking down a large financial transaction, such as a big pool of mortgages or corporate debt. By segregating these financial instruments into various tranches (a French word meaning ‘slice’ or ‘portion’), the risk associated with the investment can be distributed according to different levels of exposure. Therefore, they allow for more detailed customization of risk-return profiles, which can be beneficial to satisfy the unique risk appetites of specific investors. Effortlessly, tranches cater to diverse demands by stipulating varying terms of credit rank, repayment order, and interest rates.The purpose of tranches extends to ensuring credit enhancement and improving the efficiency of transactions. Distinct from a single, un-tiered transaction, tranches enable investors to choose their desired level of risk and return by investing in a specific series. For instance, in a mortgage-backed security (MBS), tranches would organise mortgages according to their maturity dates and default risk. A senior tranche, having priority in payment and considered less risky, can attract conservative investors by offering lower yields in return for higher safety; whilst a junior tranche, where payment is received only after the senior tranche has been paid off, would offer higher yields to entice those willing to undertake a higher risk. In this way, the systematic, segmented structure of tranches serves to more flexibly align the preferences of both issuers and investors.

Examples

1. Mortgage-Backed Securities: Perhaps the most common example of tranches is within Mortgage-Backed Securities (MBS). MBS are created by pooling together hundreds, or even thousands, of different mortgages, and then selling the cash flows as securities. These securities are divided into different classes, or tranches, based on the risk level associated with the cash flows. The senior tranches have the lowest risk because they have the first claim on the cash flows, while the junior tranches have higher risks because they have claim only after the senior tranches are paid. 2. Collateralized Debt Obligations (CDOs): Another prime example of tranches in finance is in Collateralized Debt Obligations. In CDOs, different debt instruments like bonds, loans, etc., are combined together and the consolidated cash flows are issued as tranches to investors. Similar to MBS, these tranches are ranked according to their risk profile and return potential, with senior tranches being least risky and junior tranches being most risky.3. Initial Public Offerings (IPOs): In IPOs, tranches are formed when stocks are released in stages instead of all at once. The underwriters might offer one tranche of shares to institutional investors, like big hedge funds or pension funds, and another tranche to individuals or retail clients. The IPO of Facebook, for example, was released in tranches where a portion was offered to large institutional investors and another to the general public.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Securitization
• Collateralized Debt Obligations (CDOs)
• Mortgage-backed Securities (MBS)
• Risk Tranching
• Seniority Levels

Sources for More Information

• Investopedia
• Corporate Finance Institute
• The Balance
• Financial Dictionary