Definition
A tranche is a segment or portion of a larger deal or investment that is separated due to its distinctive risk, reward, or maturity profile. It is especially used in structured finance, where securities like mortgages are pooled together and then divvied up into smaller portions with different risk levels for sale to investors. This term can also refer to a specific portion of an offering or investment round in venture capital financing.
Phonetic
The phonetic pronunciation of the word “Traunch” is “trawnch”.
Key Takeaways
- A tranche is essentially a slice, portion or part of structured financing. It is a specific portion of debt or structured financing that is packaged with other slices to fit the risk preferences of investors.
- Each tranche has different levels of risk associated, and thus different potential return rates. Senior tranches are relatively safer with lower interest rates while junior tranches carry higher risk and therefore higher potential returns.
- Tranches are commonly found in mortgage-backed securities, collateralized debt obligations and in corporate debt offerings. They allow a diversified investment portfolio and less risk than if the investor had bought the entire unwrapped product.
Importance
A tranche is an important term in business and finance as it is used to describe a specific portion of a larger deal or investment. It’s a unique way of segregating a large amount of investment into smaller, manageable portions which have distinct characteristics such as risk, rewards, time horizon, etc. Tranches are commonly utilized in structured financing, syndicated loans, and securitized and collateralized debt products. This categorization allows different investors to invest in different tranches based on their risk tolerance and investment objectives, thus enabling access to a diverse set of potential investors. It increases the feasibility and flexibility of investment, making it a vital element in financial structuring.
Explanation
Tranches serve a crucial role in the finance and business world, mostly used in the realm of structured financing, which consists of complex financial instruments like mortgage-backed securities (MBS). Tranche, a French word meaning “slice” or “portion,” is a suitable term as it literally refers to splitting up a large pool of financial assets into smaller, manageable parts. These assets can be bundled together based on their characteristics, including risk level, maturity, and return and sold to different investors, each with their unique risk tolerance, investment horizon, and return expectations.Tranches provide a method for diversifying and managing risk, thus making high-risk investment products like MBS more attractive to risk-averse investors. For example, in mortgage-backed securities, the larger pool of mortgages is divided into various tranches, each with a different level of priority for claims on the underlying cash flows. The senior tranches have a higher claim and thus less perceived risk, attracting conservative investors. On the other hand, the junior or equity tranches with a lower claim are riskier and can appeal to investors seeking higher returns. Hence, by splitting the assets, issuers can tap into a more extensive range of investor bases, increase liquidity, and unlock more capital for their business.
Examples
1. Residential Mortgage-Backed Securities (RMBS): This is a popular example of tranches in finance. In this instance, a bank will bundle a group of residential mortgages into a security and then sell off different tranches to investors. The tranches are structured into different risk levels, with the highest-risk tranche being sold first. The risk level is usually dependent on the likelihood of the underlying mortgages defaulting.2. Commercial Mortgage-Backed Securities (CMBS): Similar to RMBS, commercial banks may bundle a portfolio of commercial mortgages (from properties like shopping centers, office buildings, etc.) and divide it into various tranches to be sold to investors. The division into tranches brings more flexibility for investors, as they can choose the level of risk and return that suits their investment strategy.3. Collateralized Debt Obligations (CDOs): These are structured financial products with various tranches. In CDOs, the bank takes a collection of different debts, like corporate bonds, car loans, or student loans, and groups them together. Then, these are divided into tranches with varying degrees of risk and return and sold off to investors. During the 2008 financial crisis, many CDOs were made up of sub-prime mortgage loans, which lead to significant losses for investors when those loans started to default in large numbers.
Frequently Asked Questions(FAQ)
What is a Tranche in finance and business terminology?
A tranche is a division or portion of a pool or whole. In finance, it specifically refers to a related security offering, such as a mortgage-backed securities, that is split into smaller pieces and then sold to investors.
What are the main purposes of tranches?
Tranches are primarily used to manage and reduce the risk of investment, and to create a diversified investment portfolio. They divide financial securities into different risk categories and optimize returns for various class of investors.
How does the risk differ between different tranches?
The level of risk typically varies between tranches. The senior tranche has the lowest risk, as they have the first claims on the cash flows of the underlying assets, followed by the mezzanine and equity tranches, which carry increased risk.
In which sectors or areas are tranches commonly used?
Tranches are widely used in the debt market, specifically in mortgage-backed securities, collateralized debt obligations, and in syndicated loan offerings.
Can you explain the term Equity Tranche?
The equity tranche is the most junior or subordinated portion in the structure of a financial product. It is the last to receive payments when the underlying assets generate cash flows and the first to absorb losses, thus bearing the highest risk.
What are Senior Tranches?
Senior tranches are the portions of a financial product that have priority in claiming cash flows generated by the underlying assets. Due to their preferential treatment, they carry the lowest risk among other tranches and are generally rated highly by rating agencies.
Why do investors choose to invest in different tranches?
Investors have different risk tolerance and investment goals. Hence, they may choose from different tranches depending on the risk and return they are willing to take. Lower-risk tranches typically offer lower yields, while higher-risk tranches offer higher potential returns.
Can the structure of tranches change?
Yes, the structure of tranches can change over time due to various factors like payment rates, prevailing interest rates, and especially if some of the underlying assets default. The risk associated with each tranche can change based on these factors.
Related Finance Terms
- Securitization – The process used by banks to transform loans and other assets into tradable securities.
- Collateralized Debt Obligations (CDOs) – A type of structured asset-backed security with different tranches that are subject to different risk levels.
- Risk Tranching – The practice of dividing a financial product into parts (tranches) with different levels of risk.
- Subordinated Debt – Debt that ranks after other debts regarding claims on assets or earnings. It often relates to tranches considered ‘below’ or more risky than senior tranches.
- Structured Finance – A highly involved financial instrument offered to large financial institutions or companies that have complex financing needs not usually met by conventional financial products.
Sources for More Information
- Investopedia: https://www.investopedia.com/terms/t/tranche.asp
- Corporate Finance Institute: https://www.corporatefinanceinstitute.com/resources/knowledge/trading-investing/tranche/
- The Balance: https://www.thebalance.com/what-are-tranches-417085
- Financial Times: https://www.ft.com/content/efa739a8-b518-11d9-b9c2-00000e2511c8
