What are Bond Tranches?
Bond tranches are usually portions of mortgage-backed securities that are offered at the same time and that typically carry different risk levels, rewards, and maturities. For example, collateralized mortgage obligations (CMO) are structured with a number of tranches that mature on different dates, carry varying levels of risk, and pay different interest rates. These securities are made up of multiple mortgage pools that have different mortgage varieties ranging from safe loans with low-interest rates to risky loans with high-interest rates.
How Bond Tranches Work
Tranches are paid sequentially starting from the senior tranches to the junior tranches. Senior tranches have a higher bond credit rating than junior tranches, although these ratings fluctuate once the debt is issued. Tranches with a first lien on underlying assets are also referred to as senior tranches and are safer investments, whereas those with a second lien are known as junior tranches. The latter is riskier since they are not secured by assets and are often purchased by specialist credit investors. The typical buyers of senior tranches are insurance firms, pension funds, and conduits.
Bond tranches can be secured or unsecured. Secured tranches are backed by an asset, whereas unsecured tranches are not. Tranches can also be senior or subordinated. Subordinated debt will absorb losses before senior debt does.
Benefits of Bond Tranches
Tranches allow investors to create a single class or several classes of securities with a higher rating than the underlying asset pool. The senior tranches with a higher rating are insulated from the risk of default of the underlying asset pool since the losses are absorbed by the junior tranches. Also, investors who invest in highly-rated securities gain exposure to other asset classes, allowing them to diversify their portfolio.
Furthermore, tranches allow investors to customize their investment strategies to their needs. For example, investors who would like to have a long-term, steady cash flow should invest in tranches with long-term maturity dates. Investors who prefer to have short-term cash flow should invest in tranches with short-term maturity dates.
Risks of Bond Tranches
Tranches are complex and may pose a problem to uninformed investors. They are complex, in that they require detailed deal-specific documentation and estimation of an asset pool’s loss distribution to ensure that the desired characteristics are delivered under all possible circumstances. Less sophisticated investors have a challenge in understanding them and are more likely to make uninformed decisions. Therefore, investors must be careful when investing in such structured securities.
Also, tranches are sometimes given a higher rating than they deserve, causing investors to invest in riskier assets than they would prefer. The over-rating is mainly due to modeling the performance of tranche transactions based on historical performance rather than on real-time performance.
Take our fixed-income fundamentals course to learn more about bond tranches, and see the CFI resources listed below.