Tranching

The world of finance is complex, with many different structures, one known as “Tranche”. This type of structured finance is actually one of several related securities that are offered under the same transaction. This French word translates to “slice”, “portion”, “section”, or “series”, it means that for every bond purchased, there are different slices, each representing a portion of the risk.

Now, when referring to transaction documents, this usually means that tranches include different classes of notes. For these, each has an identifying letter to include Class A, Class B, and Class C for securities. In addition, the bonds would be given a unique rating, which is known as the “bond credit rating.” Therefore, when referring to tranching, it means this determination of risk is used outside of structured finance, usually in other venues.

To understand the way tranching works, it is important to understand that all tranches are comprised of the deal’s capital structure, which is the liability structure. Typically, tranches are paid sequentially, starting with the most mature and moving down to the lowest subordinate. However, there are some tranches associated with the same security that are paid pari passu. Of course, the more mature or senior tranches would also have the higher bond rating such as AAA, AA, or A, whereas a junior or subordinate, or an unsecured tranche might have a rating of BB.

Additionally, the legal document that governs the deal would outline in detail the payment schedule and amount for the tranche. The section of the document where this information would be listed is called the “waterfall” simply because no flow down money is involved. Then, tranching could be considered as a first lien on assets of the asset pool. In this case, the tranche is called the senior tranche. Of all tranching options, this is considered the lowest risk. When investors get involved with securities of this type, they usually use conduits, pension funds, insurance companies, or various investors who are averse to risk.

A tranche could be a second lien of assets as well or set up as no lien at all. In this case, the tranching would involve a junior or subordinate tranche. Of the two options, tranches that include junior or lower-level notes are generally riskier. The reason is that these tranches have no security or protection associated with assets. For this reason, when buyers choose securities of this type, they often hedge funds. In fact, research shows that investors who prefer junior or lower tranching are actually specialist with a broader and less specialized approach.

While tranching comes with risks, there are also many benefits. For one thing, tranches make it possible for one or more classes of securities to be created with a higher rating over the average rating of the collateral asset pool. Using credit support that has been specified in the transaction structure, these securities can be created using a variety of risk-return profiles. Another benefit associated with tranching is that they provide an opportunity in some circumstances whereas other securities would not be helpful. For instance, an investor can gain exposure to asset classes by investing in securities with high ratings such as senior tranches.

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