Navigating the financial markets can be particularly tricky owing to the fact that they are known to be volatile. They can react to local and global news, general changes in the economy and governance and the issuance of new laws among other factors. Owing to these very facts, beginners and experts alike can have a hard time selecting viable investments for themselves. Different investors have different risk profiles and financial considerations to take into account that impact how they choose to have their investment portfolios allocated. Among the investment vehicles, investors may consider tranches. This article seeks to examine all that these segments entail.
The term tranche refers to segments brought forth by a group of securities that ordinarily stem from debt instruments which could range from bonds to mortgages. This pool of securities is then divided up keeping in mind certain characteristics such that they are marketable to a wide range of investors. These characteristics can focus on risk or the time to maturity among others.
Each section or tranche of a structured or securitized product is but one of many related securities that are offered simultaneously. They differ in terms of the risks applicable to them, the rewards generated and periods for maturities. These differences allow them to gain credence among a diverse set of investors.
The term tranche is derived from the French language and its literal meaning is slice or portion. Tranches are often found in asset-backed securities (or ABSs) and mortgage-backed securities (or MBSs).
Understanding the Basics
Structured finance has only recently begun incorporating the concept of tranches. This is owed to the increasing use of securitization. With it, dividing potentially risky financial products is a possibility with the aid of steady cash flows. These divisions are then sold to investors.
The smaller tranches of broader asset pools are ordinarily defined within documentation pertaining to transactions. They are allocated different classes of notes that each holds a varied bond credit rating.
It isn’t uncommon for senior tranches to hold assets that have higher credit ratings in comparison to junior tranches. It is important to note that senior tranches have the primary lien (or security right) on the assets under consideration. This means they stand to be repaid first in instances of defaults. Junior tranches on the flip side hold a second lien or none at all.
Financial products that are commonly broken down into tranches include but aren’t limited to loans, insurance policies, bonds, and mortgages among other debts.
Assessing the Role of Tranches in Mortgage-Backed Securities
Tranches are frequently used financial structures employed within securitized debt products including collateralized debt obligations (or CDOs). These products pool together or amass cash-flow creating assets. These range from mortgages, bonds and loans to mortgage-backed securities.
Mortgage-backed security (or MBS) is composed of several mortgage pools that have a broad range of loans. These range from those that are safe and hold low-interest rates to those that are risky and have higher interest rates. Every mortgage pool has a time frame for maturity which takes into account the risks associated with it and the reward benefits. Owing to this fact, tranches are sliced into varied mortgage profiles with each slice featuring financial terms that are appropriate for diverse investors.
Take for instance a collateralized mortgage obligation (or CMO) which features divided mortgage-backed securities portfolios that have 1-year, 2-year, 5-year and 20-year maturities that each have different yields. Should an investor seek to buy an MBS, they have the freedom to select a tranche type that is in sync with their appetite for return and their threshold for risk. Z-tranches refer to the lowest-ranked tranches featured within a CMO when looking at security. Those in possession of such tranches aren’t entitled to any coupon payments and receive no cash flow via underlying mortgages. This holds true until the comparatively senior tranches retire or are paid off.
Investors are the recipients of cash flow on a monthly basis in accordance with the MBS tranche that they invested in. They have the option to either aim to sell it and garner a fast profit or hold onto it. If they choose this course of action, they can realize small but long-term gains provided as interest payments. Such monthly payments form parts of the greater interest payments that homeowners holding mortgages made and are featured under a given MBS.
Investment Strategy for Selecting Tranches
Investors who seek out long-term cash flows that are consistent gravitate towards tranches that have longer maturity periods. On the flip side investors that seek more prompt but lucrative income streams tend to go for tranches that have shorter periods of maturity.
Regardless of the interest and maturity applicable, all tranches permit investors to tailor investment strategies such that they are aligned with their specific needs. That being said, tranches aid banks and other financial institutions in attracting investors spread across varied profiles.
Tranches contribute to the complex nature of debt investing. On occasion, they may be problematic for uninformed investors who hold the risk of selecting tranches that aren’t in sync with their investment goals.
Those seeking to invest in tranches should be wary of mis-categorizations by credit rating agencies. In the event that tranches are given superior ratings than what they deserve, investors can end up being exposed to riskier assets than they originally planned. This misleading occurred and contributed to the mortgage meltdown of 2007 which consequently led to the financial crisis. Here, tranches made up of junk bonds or sub-prime mortgages held AAA labels owing to incompetence, carelessness, and corruption on the agencies’ part.