Tranche, Tranches

A tranche is one of the several securities offered as part of a financial transaction. Tranches are often used in large transactions such as collateralized mortgage obligations (CMO). They act as a means of assuring investors that some sort of regularity will be maintained during the payment of premiums on the investment.[br]  

A tranche is one of the several securities offered as part of a financial transaction. Tranches are often used in large transactions such as collateralized mortgage obligations (CMO). They act as a means of assuring investors that some sort of regularity will be maintained during the payment of premiums on the investment.[br]  

Function of a Tranche

To understand the function of a tranche, you can consider a large transaction consisting of several components. Investors in this large transaction rarely pay the entire part of their investment in the security in one go. They usually pay for each activity in small portions or increments at a given time. These increments are called staged investments or tranches. 

Types of Tranches

Each tranche in a deal has a different risk associated with the deal and are generally divided in different “classes” of notes. Each class is identifiable with a letter, such as the Class A security, Class B security and Class C security. All these tranches clubbed together form a capital or liability structure of a deal. The tranches are broadly classified as:

• Senior Tranche: These are low-risk investment instruments, and usually have an AAA, AA or A rating. When payments are made, these tranches are paid back the first. These tranches are usually secured by assets. Thus, if a company is unable to repay the investment in this tranche, its assets are sold to make the repayment. Thus, this tranche is preferred by investors having low risk appetite, conduits, insurance companies and pension funds.[br]

• Junior Tranche: These are the high risk financial instruments and usually are conferred BB rating for rating agencies such as Standards & Poors and Fitch Ratings. When a company repays the investment in one of its deal, this is the tranche that is paid the last. These tranches are not secured by assets as a result of which investors might lose their investments if the company fails to repay. Junior tranches are thus purchased by hedge funds and investors with high-risk appetite and goals for higher returns. 

 

Securitized bonds are often structured using a tranche approach. When structured properly, the end result is generally profitable for both the issuers of the bonds as well as the entities that purchase and resell the portions of the bond.