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In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see indenture) usually defines the tranches as different "classes" of notes, each identified by letter (e.g., the Class A, Class B, Class C securities) with different bond credit ratings.

The term tranche is used in fields of finance other than structured finance (such as in straight lending, where multi-tranche loans are commonplace), but the term's use in structured finance may be singled out as particularly important. Use of "tranche" as a verb is limited almost exclusively to this field.

The word tranche means a division or portion of a pool or whole [1] and is derived from the French for 'slice', 'section', 'series', or 'portion', and is also a cognate of the English 'trench' ('ditch').

How tranching works

All the tranches together make up what is referred to as the deal's capital structure or liability structure. They are generally paid sequentially from the most senior to most subordinate (and generally unsecured), although certain tranches with the same security may be paid pari passu. The more senior rated tranches generally have higher bond credit ratings (ratings) than the lower rated tranches. For example, senior tranches may be rated AAA, AA or A, while a junior, unsecured tranche may be rated BB. However, ratings can fluctuate after the debt is issued, and even senior tranches could be rated below investment grade (less than BBB). The deal's indenture (its governing legal document) usually details the payment of the tranches in a section often referred to as the waterfall (because the monies flow down).

Tranches with a first lien on the assets of the asset pool are referred to as senior tranches and are generally safer investments. Typical investors of these types of securities tend to be conduits, insurance companies, pension funds and other risk averse investors.

Tranches with either a second lien or no lien are often referred to as "junior notes". These are more risky investments because they are not secured by specific assets. The natural buyers of these securities tend to be hedge funds and other investors seeking higher risk/return profiles.

"Market information also suggests that the more junior tranches of structured products are often bought by specialist credit investors, while the senior tranches appear to be more attractive for a broader, less specialised investor community".[2] Here is a simplified example to demonstrate the principle:

Example

Benefits

Tranching offers the following benefits:

Risks

Risk, Return, Rating & Yield relate
Risk, Return, Rating & Yield relate

Tranching poses the following risks:

See also

References

  1. ^ "tranche". Merriam-Webster Dictionary.
  2. ^ a b c I. Fender, J. Mitchell "Structured finance: complexity, risk and the use of ratings" BIS Quarterly Review, June 2005
  3. ^ "The role of ratings in structured finance: issues and implications" Committee on the Global Financial System, January 2005
  4. ^ The mother of all (RMBS) tranche warfare, Financial Times Alphaville, Tracy Alloway, Oct 11 2010
  5. ^ The Financial Innovation That Wasn’t. Rortybomb, Mike Rorty, transcript of Milken Institute Conference, May 2008