A tranche is a “slice” of an investment in pooled securities, commonly debt instruments such as mortgages, that is sold separately to investors. Tranching allows investors to choose to invest in a part of the pool with similar risks and rewards. Tranches are common in asset-backed securities (ABS) and collateralized debt obligations (CDOs).
Asset-backed securities (ABS) are pooled investments, usually consisting of debt instruments such as mortgages or bonds. Banks securitize the individual loans by using their cash flows to create an asset that is then sold to investors on the secondary market. That allows the bank, the original lender, to sell some of the risk of holding the loans until maturity while also giving it new capital to lend.
One common type of ABS is a collateralized debt obligation (CDO). The pooled assets that back a CDO can include auto loans, credit card debt, mortgages, or corporate debt. They are “collateralized” because the promised repayments of the loans are the collateral that gives the CDOs their value.
Tranching is common with a mortgage-backed security (MBS). These securities are made from a pool consisting of a wide range of mortgages, ranging from safer loans that have lower interest rates and/or shorter maturities to riskier ones with higher rates and/or longer maturities.
Each mortgage pool has its own average maturity and its own credit rating based on its collective risk. Tranches are made to create “slices” of the various mortgages to appeal to investors with different risk and return expectations.
For example, a senior tranche would appeal to investors with lower risk tolerance than a junior tranche.
How a Tranche Works in Investing
Tranches are ranked according to credit risk. Senior tranches are based on debt with less risk, e.g., shorter maturities or higher-quality debt, than junior tranches. Investors can choose to invest in a specific tranche based on its risk and expected cash flows.