Tranche

This article's lead section may be too short to adequately summarize the key points. Please consider expanding the lead to provide an accessible overview of all important aspects of the article. (July 2024)

Part of a series on
Financial markets
Public market Exchange · Securities
Bond market
Bond valuation Corporate bond Fixed income Government bond High-yield debt Municipal bond Securitization
Stock market
Common stock Growth stock Preferred stock Registered share Shareholder Stock Stockbroker Stock certificate Stock exchange Watered stock
Other markets
Derivatives (Credit derivative Futures exchange Hybrid security) Foreign exchange (Currency Exchange rate) Commodity ETF Money Mutual fund Option Real estate Reinsurance Structured product Swap (finance)
Alternative investment
Private equity Private credit Leveraged buyout Venture Growth Secondaries SPAC Carried Interest Leveraged finance
Over-the-counter (off-exchange)
Forwards Options Spot market Swaps
Trading
Participants Regulation Clearing
Related areas
Asset management Banks and banking Bulls and Bears Diversification ESG Climate finance Eco-investing Impact investing Sustainable finance Greenwashing Fintech Investment management Market risk Market trend Speculative attack
v t e

In structured finance, a tranche (French pronunciation: [tʁɑ̃ʃ]) 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 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').

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.

All the tranches together make up what is referred to as the deal's

(because the monies flow down).

Tranches with a

.

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

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:

For example:

• A bank transfers risk in its loan portfolio by entering into a
  special purpose vehicle
  (SPV).
• The SPV buys
  government bonds
  ).
• The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
  • Tranche D absorbs the first 25% of losses on the portfolio, and is the most risky.
  • Tranche C absorbs the next 25% of losses
  • Tranche B the next 25%
  • Tranche A the final 25%, is the least risky.
• Tranches A, B and C are sold to outside investors.
• Tranche D is bought by the bank itself.

Tranching offers the following benefits:

• Tranches allow for the "ability to create one or more classes of securities whose rating is higher than the average rating of the underlying collateral asset pool or to generate rated securities from a pool of unrated assets".^[2] "This is accomplished through the use of credit support specified within the transaction structure to create securities with different risk-return profiles. The equity/first-loss tranche absorbs initial losses, followed by the mezzanine tranches which absorb some additional losses, again followed by more senior tranches. Thus, due to the credit support resulting from tranching, the most senior claims are expected to be insulated - except in particularly adverse circumstances - from default risk of the underlying asset pool through the absorption of losses by the more junior claims."^[3]
• Tranching can be very helpful in many different circumstances. For those investors that have to invest in highly rated securities, they are able to gain "exposure to asset classes, such as leveraged loans, whose performance across the business cycle may differ from that of other eligible assets."^[2] So essentially it allows investors to further diversify their portfolio.

Tranching poses the following risks:

• Tranching can add complexity to deals. Beyond the challenges posed by estimation of the asset pool's loss distribution, tranching requires detailed, deal-specific documentation to ensure that the desired characteristics, such as the seniority ordering the various tranches, will be delivered under all plausible scenarios. In addition, complexity may be further increased by the need to account for the involvement of asset managers and other third parties, whose own incentives to act in the interest of some investor classes at the expense of others may need to be balanced.
• With increased complexity, less sophisticated investors have a harder time understanding them and thus are less able to make informed investment decisions. One must be very careful investing in
  structured products. As shown above, tranches from the same offering have different risk, reward, and/or maturity
  characteristics.
• Modeling the performance of tranched transactions based on historical performance may have led to the over-rating (by ratings agencies) and underestimation of risks (by end investors) of asset-backed securities with high-yield debt as their underlying assets. These factors have come to light in the subprime mortgage crisis.
• In case of default, different tranches may have conflicting goals, which can lead to expensive and time-consuming lawsuits, called tranche warfare (punning on trench warfare).^[4] Further, these goals may not be aligned with those of the structure as a whole or of any borrower—in formal language, no agent is acting as a fiduciary. For example, it may be in the interests of some tranches to foreclose on a defaulted mortgage, while it would be in the interests of other tranches (and the structure as the whole) to modify the mortgage. In the words of structuring pioneer Lewis Ranieri:^[5]

  The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fiduciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary.

• Pooled investment
   – Way of investing money alongside other investorsPages displaying short descriptions of redirect targets
• Privatization – Transferring something from the public sphere to the private
• Thomson Financial League Tables
   – Financial technology companyPages displaying short descriptions of redirect targets
• Subprime mortgage crisis – 2007 mortgage crisis in the United States