The dictionary meaning of the word Tranche is -“one of several parts of a larger unit- generally of a financial arrangement, payment, or amount.” In the financial world, it refers to a security stock or bond that is divided into smaller portions to be sold to investors. For example, Home Mortgages are pooled, and security is created out of it called Mortgage-backed security (MBS), wherein investors can buy small portions in the way of Tranches. In other words, they can invest in a portion with similar risks and rewards. Thus, they can choose which tranche suits their investment style and invest accordingly. There are several types of tranches, depending upon the nature of the security, time horizon, and credit rating. Investors can choose reward portions based on their risk appetite.
Tranches are mostly used with bundles of derivatives which are based on mortgages of houses and other debt. These derivatives get their value from underlying securities like stocks, bonds, and home loans. For example, it may be valued on the basis of interest earned from a pool of home loans. These bundles of derivatives are called Collateralized Debt Obligations- CDO and include personal loans, mortgages, credit card debt, and even corporate debt. Such bundles are sold to investors in the form of tranches at different rates of interest. This interest rate is based on specific factors like the maturity period and credit ratings.
Types of Tranches
Based on the Nature of Security
Tranches are most common with mortgage-backed securities – MBS, which are based on home loans. They are asset-backed securities – security being the mortgage itself or a collection of mortgages. Such securities pay an interest rate based on the interest rate of a collection of home loans in the fund.
Interest rates in every mortgage vary. Usually, a borrower pays low-interest rates for the initial few years and a higher rate thereon. As the rates are low, the default risk is very low in the initial years. This risk gets higher with every passing year. Also, in the later years, borrowers tend to sell or refinance their houses.
The above situation creates different types of investors. Tranches are thus created to cater to their respective needs. Low-rate Tranche caters to Low-risk years and High-risk years get a higher rate tranche.
Tranches are also used with Asset-Backed Commercial Paper. These are based on a bundle of corporate debt.
Based on the Maturity Period
Tranches can also be classified based on their maturity dates- maturing in a year, three years, five years, etc. Investors invest based on their risk appetite and need for the return of their money. Those seeking a return on their investment in the short-term can go for shorter-duration tranches. Those with a longer time horizon can invest in longer-maturity tranches.
Based on Credit Ratings
Tranches can also be classified based on their respective ratings. Low-risk Tranches have a senior rating. Hence they have higher bond credit ratings. They have a first lien on the assets of the asset pool or security pool. Lower-rated tranches are riskier and therefore have lower credit ratings. They may have a second lien or even no lien on the assets of the pool.
Senior-rated Tranches are the safest investments and get ratings AAA, AA, or A. At the same time, a BB or B-rated Tranche will be more risky or unsecured.
Advantages of Tranches
- Tranches include both high-quality debt and junk instruments and thus provide an opportunity to create higher rating security than the overall rating of the collateral asset pool. Altogether new and better risk-return security come into existence from poor and under-rated securities.
- Tranches help the investors to diversify their investment portfolio and channelize their funds according to their risk-taking capability and investment horizon. High-risk Tranches can provide an opportunity to reap high returns on investment.
Disadvantages of Tranches
- Some types of Tranches can be very risky for individual investors. It is very difficult to know the real value of the underlying asset. They are complex and thus can be very difficult to understand and determine their true worth. Credit rating agencies can miscategorize tranches because of which undeserving higher ratings can expose investors to higher risk than their potential.
- In the case of falling markets, prices of securities fall because of which it becomes extremely difficult to correctly price the mortgage-based securities and subsequently the Tranches. The Financial crisis of 2008 is an appropriate example to show how risky Tranches with Mortgage-based Securities can be when the housing market plummeted. Home prices in the US started falling after peaking in mid-2006. Borrowers could not refinance their loans, nor could they meet their monthly payments. Thus, mortgage delinquencies started. Mortgage-backed securities lost most of their value, whereby global investors, including banks, lost a lot of money. As a result, financial markets across the world crashed.
- Tranches with a higher rating will be first paid off. Lower-rated Tranches will come next. Investors can lose money in such Tranches and even get back nothing.
The various types of Tranches seek to spread investment and interest rate risk across various securities. Individuals should be extremely cautious while dealing with such products since they require specialized knowledge and information. Specialized institutions like banks and insurance companies can be a useful medium to trade in Tranches only until they maintain good lending standards. Greed and over-optimism on their part can destroy investor money, as was the case during the Financial crisis of 2008.