Definition
A tranche is a segment of a mortgage-backed security (MBS) or other types of structured financial product divided based on risk level or maturity. Each tranche is a piece of the overall asset pool, with cash flow distributed to various tranches based on their priority and structure. Different tranches are designed to meet the specific demands of various investors who are looking for different levels of risk and return.
Examples
-
Collateralized Mortgage Obligations (CMOs):
- CMOs are organized as securities backed by a pool of home loans (mortgages).
- For instance, a CMO might be divided into tranches of five-year periods. An investor opting for an early tranche will receive both interest payments and part of the principal balance repaid sooner compared to those in latter tranches.
-
Principal Risk Allocation:
- In a sale of CMOs, different investor groups might take turns on the risk ladder regarding principal repayment.
- One group might have rights to the first 80% of principal repayments, another for the next 10%, and the highest-risk group for the final 10%.
Frequently Asked Questions (FAQs)
What is the purpose of dividing an MBS into tranches?
Dividing an MBS into tranches allows for the creation of diversified products that meet different investor needs for risk, maturity, and return. Some investors may prefer the stability of senior tranches, while others may seek higher returns in riskier subordinate tranches.
How are payments distributed among different tranches?
Payments are generally made in sequence, starting with the senior tranches receiving their due payments first, followed by subordinate tranches. If there are defaults, the lower tranches may not receive any payments, absorbing the initial losses.
Why do tranches have different risk levels?
The structuring of tranches differentiates them by prepayment risk, credit risk, and interest rate risk. Senior tranches have the least risk since they are the first to be paid in the cash flow sequence. Subordinate tranches assume higher risk and thus offer higher potential returns.
Can investors switch between tranches post-purchase?
Typically, investors cannot switch between tranches post-purchase as they are bound by the terms of the investment they initially opted for. However, they can sell their tranche investment on the secondary market.
Are tranches only applicable to MBS?
No, while tranches are commonly used in MBS, they can also apply to other structured finance products like Collateralized Debt Obligations (CDOs), asset-backed securities (ABS), and certain kinds of annuities.
Related Terms
- Mortgage-Backed Security (MBS): Securities backed by a pool of mortgages that pay investors through mortgage repayments.
- Collateralized Mortgage Obligation (CMO): A type of MBS that categorizes debt by tranches with differing risk and payout schedules.
- Credit Risk: The risk that a borrower will default on a loan, impacting the security’s value.
- Prepayment Risk: The risk that loans in a security get paid off earlier than expected, reducing total interest income.
- Asset-Backed Security (ABS): Securities that are backed by other types of financial assets, besides mortgages.
Online Resources
- Investopedia - Tranches
- SEC - Introduction to Mortgage-Backed Securities>
- Federal Reserve - Guide to Collateralized Mortgage Obligations
References
- Fabozzi, F. J., “Fixed Income Analysis,” CFA Institute Investment Series.
- Fabozzi, F. J., “The Handbook of Mortgage-Backed Securities,” 7th edition.
Suggested Books for Further Study
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi
- “Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization” by Janet Tavakoli
- “Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques” by Frank J. Fabozzi
