What is a tranche?

A tranche is a portion or slice of a larger financial product or investment. They are commonly used in the context of structured finance, such as mortgage-backed securities (MBS) or collateralized debt obligations (CDOs).

Tranches are created by dividing the cash flows or income generated from the underlying assets into different groups, each with its own level of risk and return. These divisions help investors understand and choose the level of risk they are willing to take.

Tranches are often ranked in order of priority, known as seniority. The senior tranches are paid first and have the least amount of risk. They have a higher credit rating and offer lower yields. On the other hand, the junior or subordinated tranches have higher risk and offer higher yields, but they are also last in line for repayment if there is a default or other adverse event.

Tranches are designed to meet the needs of different investors with varying risk profiles. This allows financial institutions to package and sell these tranches to a wide range of investors, including pension funds, insurance companies, asset managers, and individual investors.

One example of a tranche is the tranches in a mortgage-backed security (MBS). In an MBS, the underlying asset is a pool of mortgages. These mortgages are grouped into different tranches based on criteria such as credit quality or loan-to-value ratios. Investors can then choose to invest in a particular tranche based on their risk appetite and investment goals.

Tranches have been criticized for their contribution to the 2008 financial crisis, where the complex and opaque nature of these structures made it difficult to assess and manage the underlying risks. However, when used properly, tranches can provide investors with diversification and customization benefits.