Tranching

 

 

When a company is undertaking a large transaction, it can break down the payment on the deal into small portions or tranches. Tranching enables investors to participate in these large deals.[br]

 

To understand how tranching works, let us go through an example of the purchase and resale of bank instruments by a trading group. The group purchases the instruments in blocks, with a commitment to ultimately purchase all the outstanding blocks by the end of the contract. The purchase of the initial block may only be a fraction of the total cost for the shares to be bought under contract.

 

At the same time, the trading group can resell the initial block to cover the purchase price and generate a profit. The group can cover the cost of the next scheduled purchase of a tranche through its profits and repeat the sale process. In this pattern, everyone involved in the deal can benefit.

 

Benefits of Tranching

Tranching offers the following benefits:

• They enable the creation of one or more classes of securities whose rating is higher than the average rating of the underlying collateral asset pool. Through tranching, these companies can also generate rated securities from a pool of unrated assets. This is done by using the credit support specified within the transaction structure to create securities having diverse risk-return profiles. While the equity/first-loss/junior tranches absorb initial losses, mezzanine tranches only absorb losses when the junior tranches cannot take on more. Senior tranches are the most insulated from losses, except in extremely adverse circumstances. Moreover, as senior tranches are secured by underlying asset pool, any losses are generally recovered by the sale of these assets.

• Tranching allows investors to further diversify their portfolio. Investors who want to invest in highly-rated securities can gain exposure to asset classes, such as leveraged loans. [br] 

Disadvantages of Tranching

However, tranching is not without risks.

• It can make financial deals more complex. Apart from the challenges posed by estimation of loss distribution to the asset pool, tranching necessitates detailed, deal-specific documentation. This ensures that characteristics, such as the senior tranches getting loss insulation, is achieved under all possible scenarios. The need to account for the involvement of asset managers and third party further increases the complexity.

• An increase in complexity makes it difficult for less sophisticated investors to understand tranching. This hampers their ability to make informed investment decisions, which is very crucial when investing in structured products. This is because tranches from the same offering can have diverse risk, reward and maturity characteristics.