What is a Tranche?
In the world of finance and investments, a tranche usually refers to a specific part of a larger transaction. The word tranche is actually French, and is translated into English as “portion” or “part.” Tranches are often used in such larger transactions as collateralized mortgage obligations as a means of assuring investors of some sort of regularity in the payment of premiums on the investment. To understand the function of the tranche, it is helpful to see a large transaction as containing a subset of components, with investors funding the activity a little at a time. Investors in these types of transactions rarely pay a lump sum in return for their share of investment in the security. Instead, they will pay in increments that are sometimes referred to as staged investments or tranches. The purchase and resale of bank instruments by a trading group is an excellent example of how a tranche works. The instruments are purchased in blocks, with commitments to eventually purchase all outs
“Tranche” is actually a French word meaning “slice” or “portion”. In the world of investing, it is used to describe a security that can be split up into smaller pieces and subsequently sold to investors. Mortgage-backed securities (MBS), such as a collateralized mortgage obligation (CMO), can often be found in the form of a tranche. These securities can be partitioned based on their maturities and then sold to investors based on their preferences. For example, an investor might need cash flows in the short term and have no desire to receive cash in the future. Conversely, another investor could have a need for cash flows in the long term but not right now. To take advantage of this selling situation, an investment bank could split some security or asset, such as a CMO, into different parts so that the first investor receives the early cash flows of a mortgage and the second investor has the right to receive the latter cash flows. With the creation of these tranches, a security or issue
A tranche identifies a slice of a security (typically a bond or other credit linked security) which is funded by investors who assume different risk levels within the liability structure of a security. This risk can come in the form of a variety of factors; term to maturity, geographic exposure, and even repayment tiers. Tranche’s essentially describe the repayment risk that an investor is willing to take; with the higher risk investors receiving higher yields. Tranche Tiers Tiered tranches typically repay investors sequentially from highest rated to lowest rated, this is commonly known as “waterfall” since payments flow down from highest to lowest. There are typically three major tranche tiers; Senior and Mezzanine, and Equity. They can be distinguished by their credit ratings; for example, senior tranches are classified as triple A rated debt while mezzanine is AA to BB, and equity is considered “toxic waste” or unrated. In the event of a default, it is highly unlikely that the equit