Tranches: What are they?

What are Tranches?

• In finance, a tranche is one of a number of related investment securities, offered as a part of the same transaction. The word, ‘tranche’ is derived from the French word tranche, which means for slice, series, portion or section of.

• In regards to finance, tranches are attached to bonds or other debt securities to signify a slice of the whole investment’s risk portfolio. For instance, a large bond or collateralized mortgage obligation will be divided into different tranches; each tranche is identified by a latter) for example, Class A, Class B and Class C securities) to signify the splice’s bond credit rating.

How do Tranches work?

• When combined, all the tranches make up what is referred to as the transaction’s capital structure or liability structure. All tranches, as stated before, are attached with different bond credit ratings depending on the level of risk associated with the particular tranche. In addition to level of risk, tranches are typically paid sequentially from the most senior to the most unsecured groupings. The more senior-rated tranches (less risk due to minimal probability of default) are met with higher bond credit ratings than the lower-rated tranches. For example, senior tranches may be rated AAA, AA or A, while an unsecured or junior tranche may be rated BBB, BB or B.

• Tranche ratings can fluctuate once the debt is issued; the transaction’s indenture (the purchase agreement which legally upholds the transaction) will typically detail the payment of the tranches in the “waterfall” section of the agreement.

• Those tranches with the first lien on the underlying assets of the pool are labeled as “senior” and are regarded as the safer tranche class. Typically investors of these tranches are insurance companies, risk averse consumers and pension funds.

• Tranches with a second or no lien are referred to as “junior notes”. These investment options are more risk because they are not secured by a tangible asset. The natural buyers of these tranches tend to be hedge funds and other investors who seek higher returns.

What are the Benefits of Tranches?

• Tranches allow for the ability to create numerous classes of securities whose rating will help inform a potential investor as to the inherent risk of the investment option. The tranches also tangibly organize the assets and clearly label them (through the issuance of a bond rating) with a rating classification. Additionally, tranches enable investors to efficiently diversify their portfolio.

What are the Risks associated with Tranches?

• Tranches are considered complex investment options. In addition to the challenges posed by estimating the asset pool’s loss distribution, tranching requires deal-specific documentation to ensure that the desired characteristics will delivered in the respective deal.

• Furthermore, complexity may be further increased by the need to include asset managers and third parties in the transaction. This complexity clouds the investment decisions of less sophisticated buyers of tranches. When evaluating tranches and other structured products, one must be careful when evaluating the different levels or risk, reward and maturity characteristics associated. Similar to other debt instruments, tranches carry the risk of default.