Tranche

In structured nance, a tranche is one of a number of

related securities oered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench ('ditch').
In the nancial sense of the word, each bond is a dierent slice of the deals risk. Transaction documentation
(see indenture) usually denes the tranches as dierent
classes of notes, each identied by letter (e.g., the Class
A, Class B, Class C securities) with dierent bond credit
ratings (ratings).

cialist credit investors, while the senior tranches appear to

be more attractive for a broader, less specialised investor
community.[1] Here is a simplied example to demonstrate the principle:

1.1 Example
A bank transfers risk in its loan portfolio by entering
into a default swap with a ring-fenced special purpose vehicle (SPV).

The term tranche is used in elds of nance other than

structured nance (such as in straight lending, where
multi-tranche loans are commonplace), but the terms use
in structured nance may be singled out as particularly
important. Use of tranche as a verb is limited almost
exclusively to this eld.

The SPV buys gilts (UK government bonds).

The SPV sells 4 tranches of credit linked notes with
a waterfall structure whereby:
Tranche D absorbs the rst 25% of losses on
the portfolio, and is the most risky.

How tranching works

Tranche C absorbs the next 25% of losses

Tranche B the next 25%

All the tranches together make up what is referred to as
the deals capital structure or liability structure. They are
Tranche A the nal 25%, is the least risky.
generally paid sequentially from the most senior to most
subordinate (and generally unsecured), although certain
Tranches A, B and C are sold to outside investors.
tranches with the same security may be paid pari passu.
Tranche D is bought by the bank itself.
The more senior rated tranches generally have higher
bond credit ratings (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.
2 Benets
However, ratings can uctuate after the debt is issued
and even senior tranches could be rated below investment
grade (less than BBB). The deals indenture (its govern- Tranching oers the following benets:
ing legal document) usually details the payment of the
tranches in a section often referred to as the waterfall (be Tranches allow for the ability to create one or more
cause the moneys ow down).
classes of securities whose rating is higher than the
average rating of the underlying collateral asset pool
Tranches with a rst lien on the assets of the asset pool
or to generate rated securities from a pool of unare referred to as senior tranches and are generally safer
rated assets.[1] This is accomplished through the
investments. Typical investors of these types of securities
use of credit support specied within the transactend to be conduits, insurance companies, pension funds
tion structure to create securities with dierent riskand other risk averse investors.
return proles. The equity/rst-loss tranche absorbs
Tranches with either a second lien or no lien are often
initial losses, followed by the mezzanine tranches
referred to as junior notes. These are more risky inwhich absorb some additional losses, again followed
vestments because they are not secured by specic assets.
by more senior tranches. Thus, due to the credit supThe natural buyers of these securities tend to be hedge
port resulting from tranching, the most senior claims
funds and other investors seeking higher risk/return proare expected to be insulated - except in particularly
les.
adverse circumstances - from default risk of the unMarket information also suggests that the more junior
derlying asset pool through the absorption of losses
tranches of structured products are often bought by speby the more junior claims.[2]
1

5
Tranching can be very helpful in many dierent 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 dier
from that of other eligible assets.[1] So essentially it
allows investors to further diversify their portfolio.

Risks

REFERENCES

In case of default, dierent tranches may have conicting goals, which can lead to expensive and timeconsuming lawsuits, called tranche warfare (punning on trench warfare).[3] Further, these goals may
not be aligned with those of the structure as a whole
or of any borrowerin formal language, no agent
is acting as a duciary. For example, it may be in
the interests of some tranches to foreclose on a defaulted mortgage, while it would be in the interests
of other tranches (and the structure as the whole) to
modify the mortgage. In the words of structuring
pioneer Lewis Ranieri:[4]
The cardinal principle in the mortgage crisis is a
very old one. You are almost always better o
restructuring a loan in a crisis with a borrower
than going to a foreclosure. In the past that was
never at issue because the loan was always in
the hands of someone acting as a duciary. The
bank, or someone like a bank owned them, and
they always exercised their best judgement and
their interest. The problem now with the size
of securitization and so many loans are not in
the hands of a portfolio lender but in a security
where structurally nobody is acting as the duciary.

Risk, Return, Rating & Yield relate

Tranching poses the following risks:

Tranching can add complexity to deals. Beyond the
challenges posed by estimation of the asset pools
loss distribution, tranching requires detailed, dealspecic 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 others 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 oering have dierent risk, reward, and/or
maturity characteristics.
Modeling the performance of tranched transactions
based on historical performance may have led to the
over-rating (by ratings agencies) and underestimation of risks (by end investors) of asset-backed securities with high-yield debt as their underlying assets.
These factors have come to light in the subprime
mortgage crisis.

4 See also
Pooled investment
Privatization
Thomson Financial League Tables

5 References
[1] I. Fender, J. Mitchell Structured nance: complexity,
risk and the use of ratings BIS Quarterly Review, June
2005
[2] The role of ratings in structured nance: issues and implications Committee on the Global Financial System,
January 2005
[3] The mother of all (RMBS) tranche warfare, Financial
Times Alphaville, Tracy Alloway, Oct 11 2010
[4] The Financial Innovation That Wasnt. Rortybomb, Mike
Rorty, transcript of Milken Institute Conference, May
2008

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