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tranche: Definition and Much More from Answers.com

️Wed Jul 01 2015

Pardon my French! Tranche, the French word for slice, has come to mean in English a portion or a specific class of bonds within a structured finance deal. The word made it into the news when CBS Radio decided to sue its former employee, shock jock Howard Stern:

"CBS wants Stern, his agent, Don Buchwald, and Sirius to return any financial benefits they received from using CBS radio's air time to promote Sirius, including the value of a tranche of Sirius shares that Stern and Buchwald received early for exceeding a target for subscriber increases by the end of 2005."

Link: CBS Radio Sues Howard Stern

Posted March 2, 2006.

A piece, portion or slice of a deal or structured financing. This portion is one of several related securities that are offered at the same time but have different risks, rewards and/or maturities. "Tranche" is the French word for "slice".

Investopedia Says:
Tranche is a term often used to describe a specific class of bonds within an offering wherein each tranche offers varying degrees of risk to the investor. For example, a CMO offering a partitioned MBS portfolio might have mortgages (tranches) that have one-year, two- year, five-year and 20-year maturities. It can also refer to segments that are offered domestically and internationally.

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1. risk maturity or other classes into which a multi-class security, such as a Collateralized Mortgage Obligation (CMO) or a Remic is split. For example, the typical CMO has A, B, C, and Z tranches, representing fast pay, medium pay, and slow pay bonds plus an issue (tranch) that bears no coupon but receives the cash flow from the collateral remaining after the other tranches are satisfied. More sophisticated CMO versions have multiple Z tranches and a Y tranch incorporating a sinking fund schedule.

2. in the United Kingdom, fixed-rate security issues are often prearranged by governments, local authorities, or corporations, then brought out in successive rounds, termed tranches. One thus speaks of new tranches of existing securities. A variation of the term, tranchettes, refers to small tranches of gilt-edged securities (government bonds) sold by the government to the Bank of England, which then sells them into the market at times it deems appropriate.

3. subunits of a large ($10-$30 million) Eurodollar certificate of deposit that are marketed to smaller investors in $10,000 denominations. Tranches are represented by separate certificates and have the same interest rate, issue date, interest payment date, and maturity of the original instrument, which is called a tranch CD.

1. One of the classes of debt securities issued as part of a single bond or instrument, from the French word tranche, meaning slice. Securities often are issued in tranches to meet different investor objectives for portfolio diversification. For example, a Collateralized Mortgage Obligation is a mortgaged-backed security issued with several different bond tranches issued under a single bond indenture, ranging from a fast-pay bond to a long-term slow-pay bond (called the Accrual Bond, or the Z-bond). Each is paid off consecutively; as one bond matures, the next is paid down in a stepping stone progression. Each tranche has a different coupon and maturity, and is identifiable by a different Cusip Number.

2. Separate borrowings or funding commitments under a Term Loan or other credit facility. A multicurrency loan will be structured with a U.S. Dollar tranche, a deutschemark tranche, and so on. World Bank advances to a sovereign borrower are structured in tranches.

3. Single maturity Certificate of Deposit sold by a lead bank, which is then divided into smaller denominations for placement with investors.

4. Gold tranche: first 25% of a member country's contribution to the International Monetary Fund, normally in gold bullion.

5. Reserve tranche: deposit balances subject to Reserve Requirements.

A section of a Mortgage-Backed Security differentiated by maturity or by risk.
Examples:

• Collateralized Mortgage Obligations (CMOs) were issued, backed by 30-year amortizing mortgages. The CMOs were sold in five-year tranches, with investors getting interest plus the principal back at different intervals based on which tranche they acquired.

• In the sale of CMOs, one investor group acquired the rights to the first 80% of principal retired, another group to the next 10%; the final 10% will go to investors who accepted the highest risk of repayment.

In structured finance, the word tranche (sometimes traunche) refers to one of several related securitized bonds offered as part of the same deal. The word tranche is French for slice; in the financial sense of the word, each bond is a slice of the deal's risk. The legal documents (see indenture) usually refer to the tranches as "classes" of notes identified by letter (e.g. the Class A, Class B, Class C securities).

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 (usually Senior Secured) to most subordinate (generally unsecured), although certain tranches with the same security may be paid pari passu. The more senior rated tranches generally have higher 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 moneys 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. The natural buyers 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".^[1]

Example

A bank transfers risk in its loan portfolio by entering into a default swap with a "ring-fenced" SPV ("Special Purpose Vehicle")
The SPV buys gilts (UK government bonds)
The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
- Tranche A absorbs the first 25% of losses on the portfolio
- Tranche B absorbs the next 25% of losses
- Tranche C the next 25%
- Tranche D the final 25%
Tranches B, C and D are sold to outside investors
Tranche A is bought by bank itself

Benefits

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".^[1] "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."^[2]

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."^[1] So essentially it allows investors to further diversify their portfolio.

Risks

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 other 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.
Tranching has largely led to the understatement of the risks embedded in high-yield debt and asset-backed securities backing the structured products. These risks have surfaced recently in the light of the subprime meltdown.

References

^ ^a ^b ^c I. Fender, J. Mitchell "Structured finance: complexity, risk and the use of ratings" BIS Quarterly Review, June 2005
^ "The role of ratings in structured finance: issues and implications" Committee on the Global Financial System, January 2005

Structured finance
Securitization	Securitization transaction · Credit enhancement · Tranche
Types of Securities	Asset-backed security · Mortgage-backed security · Credit derivative · Collateralized debt obligation · Collateralized mortgage obligation · Collateralized bond obligation

tranche: Definition and Much More from Answers.com

How tranching works

Example

Benefits

Risks

References

See also

ProteomeCommons.org Tranche

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