Introducing Tranches as a Concept
Have you ever found yourself wondering “what are tranches?” while exploring the financial markets? If so, you have come to the right place as this article seeks to bring forth the term tranche’s definition. Today, there exist several financial products available in the market which are often categorised keeping in mind certain characteristic traits such that investors and traders alike can select them with greater ease. These categorizations can be understood to be tranches. They are segments that apply to a group of securities such as debt instruments which may be bonds or mortgages. They are then split according to the risk they face, the time they need to acquire maturity or in accordance with other characteristics that are marketable to a wide range of diverse investors.
Each segment (or tranche) of a given securitized or structured product is in fact one of many interlinked securities that are made available at the same time. However, each tranche incurs differing levels of risks, maturities and rewards that are meant to appeal to a wide range of investors.
The term tranche is derived from the French language and means slice or portion. It is widely used within mortgage-backed securities (or MBS) as well as asset-backed securities (or ABS).
Understanding the Fundamentals of Tranches
The use of tranches within structured finance is a relatively recent development that has been driven by the greater use of securitization which helps divide financial products that may be risky on occasion. This has been done with the aid of steady cash flows such that these divisions may then be sold to other investors.
The tranches that constitute a broader asset pool are ordinarily defined within transaction documentation are allocated with different classes of notes and each represents a different bond credit rating.
Among the financial products that can be divvied up into tranches are loans, bonds, mortgages, insurance policies, and other alternative debts.
Understanding the Operation of Tranches within Mortgage-Backed Securities
Securitized debt products including mortgage-backed securities and collateralised debt obligations (or CDOs), which amass a collection of cash flow-generating assets ranging from mortgages to bonds and loans, often utilise tranches as they are a common financial structure.
When looking at a mortgage-backed security, it is made up of multiple mortgage pools that consist of a wide range of loans that include safe loans that incur lower interest rates as well as risky loans that have higher rates tethered to them. There exist individual time frames for maturity that are applicable to each specific mortgage pool which ought to be taken into account when considering the risk and reward benefits applicable to it. Owing to this very fact, tranches are created to divide up the differing mortgage profiles into segments that have financial terms that are agreeable to and appropriate for specific investors.
Take for instance a collateralised mortgage obligation (or CMO) that offers partitioned mortgage-backed securities may make available mortgage tranches that have differing maturities ranging from 1 year to 20 years with each segment providing differing yields. If an investor seems keen to invest in an MBS, they can then select the tranche type that is most appropriate to their risk profile and the returns they seek. In terms of seniority, a rank of Z indicates the lowest-ranked tranche operating within a CMO. Owners of such holdings aren’t entitled to coupon payments of any kind and do not receive any cash flow from underlying mortgages until the more senior tranches have been paid off.
Investors are allocated a monthly cash flow keeping in mind the MBS tranche within which they have invested their money. They have the choice to then sell their holdings and generate a quick profit or hold onto them and realise modest but long-term gains that are provided in the form of interest payments. The monthly payments provided are in fact portions of all the interest payments that are submitted by homeowners whose mortgages are included within a specific MBS.
Investment Strategies Applicable to Choosing Tranches
Investors seeking out a long-term reliable source of cash should invest in tranches that have a longer time frame needed to acquire maturity. On the other hand, those investors who seek out more immediate and more lucrative incomes should invest in tranches that have a small-time frame needed to acquire maturity.
Regardless of interest and maturity applicable to tranches, each tranche permits investors to customise investment strategies such that they are in line with specific investor needs. That being said, tranches aid banks as well as other financial institutions in drawing in investors belonging to varying profile types.
Things to Keep in Mind Prior to Investing in Tranches
It is possible for tranches to be miscategorised by credit rating agencies. In the event that a tranche is given a higher rating than it deserves, it can lead to investors being exposed to assets that are riskier than they may be able to handle. The American mortgage crisis of 2007 was owed in large part to this form of mislabelling and played a major role in the consequent financial crisis. Tranches that held junk bonds or assets that fell below investment grades were given ratings of AAA or their equivalent either due to carelessness, incompetence or outright corruption. It is therefore always important to carefully examine what you wish to invest in prior to putting money down on it and committing to it. Adequate research can go a long way in helping you find the most appropriate investments.
