Tranche
Encyclopedia
In structured finance
, a tranche (often misspelled as traunch or traunche) is one of a number of related securities
offered 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 financial sense of the word, each bond
is a different slice of the deal's risk
. Transaction documentation (see indenture
) usually defines the tranches as different "classes" of notes, each identified by letter (e.g. the Class A, Class B, Class C securities) with different bond credit rating
s (ratings).
The term "tranche" is used in fields of finance other than structured finance (such as in straight lending, where "multi-tranche loans" are commonplace), but the term's use in structured finance may be singled out as particularly important. Use of "tranche" as a verb is limited almost exclusively to this field.
In other fields, notably aviation, the noun tranche is used to denote a block of units sharing a common standard. The Eurofighter Typhoon
which is used by a number of European air forces, was built to a number of successive tranches.
or liability structure. They are generally paid sequentially from the most senior
to most subordinate (and generally unsecured), although certain tranches with the same security may be paid pari passu
. The more senior rated tranches generally have higher bond credit rating
s (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. However, ratings can fluctuate after the debt is issued and even senior tranches could be rated below investment grade (less than BBB). The deal's indenture
(its governing legal document) usually details the payment of the tranches in a section often referred to as the waterfall (because the moneys flow down).
Tranches with a first lien on the assets of the asset pool are referred to as "senior tranches" and are generally safer investments. Typical investors of these types of securities tend to be conduits
, insurance companies, pension fund
s and other risk averse investors.
Tranches with either a second lien or no lien are often referred to as "junior notes". These are more risky investments because they are not secured by specific assets. The natural buyers of these securities tend to be hedge funds and other investors seeking higher risk/return profiles.
"Market information also suggests that the more junior tranches of structured products are often bought by specialist credit investors, while the senior tranches appear to be more attractive for a broader, less specialised investor community".
Here is a simplified example to demonstrate the principle:
Structured finance
Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid lawsStructured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws...
, a tranche (often misspelled as traunch or traunche) is one of a number of related securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
offered as part of the same transaction. The word tranche is French
French language
French is a Romance language spoken as a first language in France, the Romandy region in Switzerland, Wallonia and Brussels in Belgium, Monaco, the regions of Quebec and Acadia in Canada, and by various communities elsewhere. Second-language speakers of French are distributed throughout many parts...
for slice, section, series, or portion, and is cognate to English trench
Trench
A trench is a type of excavation or depression in the ground. Trenches are generally defined by being deeper than they are wide , and by being narrow compared to their length ....
('ditch'). In the financial sense of the word, each bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
is a different slice of the deal's risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
. Transaction documentation (see indenture
Indenture
An indenture is a legal contract reflecting a debt or purchase obligation, specifically referring to two types of practices: in historical usage, an indentured servant status, and in modern usage, an instrument used for commercial debt or real estate transaction.-Historical usage:An indenture is a...
) usually defines the tranches as different "classes" of notes, each identified by letter (e.g. the Class A, Class B, Class C securities) with different bond credit rating
Bond credit rating
In investment, the bond credit rating assesses the credit worthiness of a corporation's or government debt issues. It is analogous to credit ratings for individuals.-Table:...
s (ratings).
The term "tranche" is used in fields of finance other than structured finance (such as in straight lending, where "multi-tranche loans" are commonplace), but the term's use in structured finance may be singled out as particularly important. Use of "tranche" as a verb is limited almost exclusively to this field.
In other fields, notably aviation, the noun tranche is used to denote a block of units sharing a common standard. The Eurofighter Typhoon
Eurofighter Typhoon
The Eurofighter Typhoon is a twin-engine, canard-delta wing, multirole combat aircraft, designed and built by a consortium of three companies: EADS, Alenia Aeronautica and BAE Systems; working through a holding company, Eurofighter GmbH, which was formed in 1986...
which is used by a number of European air forces, was built to a number of successive tranches.
How tranching works
All the tranches together make up what is referred to as the deal's capital structureCapital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
or liability structure. They are generally paid sequentially from the most senior
Seniority (financial)
In finance, seniority refers to the order of repayment in the event of bankruptcy.Senior debt must be repaid before subordinated debt is repaid...
to most subordinate (and generally unsecured), although certain tranches with the same security may be paid pari passu
Pari passu
Pari passu is a Latin phrase that literally means "with an equal step" or "on equal footing." It is sometimes translated as "ranking equally", "hand-in-hand," "with equal force," or "moving together," and by extension, "fairly," "without partiality."...
. The more senior rated tranches generally have higher bond credit rating
Bond credit rating
In investment, the bond credit rating assesses the credit worthiness of a corporation's or government debt issues. It is analogous to credit ratings for individuals.-Table:...
s (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. However, ratings can fluctuate after the debt is issued and even senior tranches could be rated below investment grade (less than BBB). The deal's indenture
Indenture
An indenture is a legal contract reflecting a debt or purchase obligation, specifically referring to two types of practices: in historical usage, an indentured servant status, and in modern usage, an instrument used for commercial debt or real estate transaction.-Historical usage:An indenture is a...
(its governing legal document) usually details the payment of the tranches in a section often referred to as the waterfall (because the moneys flow down).
Tranches with a first lien on the assets of the asset pool are referred to as "senior tranches" and are generally safer investments. Typical investors of these types of securities tend to be conduits
Special purpose entity
A special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives...
, insurance companies, pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
s and other risk averse investors.
Tranches with either a second lien or no lien are often referred to as "junior notes". These are more risky investments because they are not secured by specific assets. The natural buyers of these securities tend to be hedge funds and other investors seeking higher risk/return profiles.
"Market information also suggests that the more junior tranches of structured products are often bought by specialist credit investors, while the senior tranches appear to be more attractive for a broader, less specialised investor community".
Here is a simplified example to demonstrate the principle:
Example
- A bank transfers risk in its loan portfolio by entering into a default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
with a "ring-fenced" special purpose vehicle (SPV). - The SPV buys giltsGiltsGilts are bonds issued by certain national governments. The term is of British origin, and originally referred to the debt securities issued by the Bank of England, which had a gilt edge. Hence, they are called gilt-edged securities, or gilts for short. The term is also sometimes used in Ireland...
(UKUnited KingdomThe United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
government bonds). - The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
- Tranche D absorbs the first 25% of losses on the portfolio, and is the most risky.
- Tranche C absorbs the next 25% of losses
- Tranche B the next 25%
- Tranche A the final 25%, is the least risky.
- Tranches A, B and C are sold to outside investors.
- Tranche D is bought by the bank itself.
Benefits
Tranching offers the following benefits:- Tranches allow for the "ability to create one or more classes of securities whose rating is higher than the average rating of the underlying collateral asset pool or to generate rated securities from a pool of unrated assets". "This is accomplished through the use of credit support specified within the transaction structure to create securities with different risk-return profiles. The equity/first-loss tranche absorbs initial losses, followed by the mezzanine tranches which absorb some additional losses, again followed by more senior tranches. Thus, due to the credit support resulting from tranching, the most senior claims are expected to be insulated - except in particularly adverse circumstances - from default risk of the underlying asset pool through the absorption of losses by the more junior claims."
- Tranching can be very helpful in many different 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 differ from that of other eligible assets." So essentially it allows investors to further diversify their portfolio.
Risks
Tranching poses the following risks:- Tranching can add complexity to deals. Beyond the challenges posed by estimation of the asset pool's loss distribution, tranching requires detailed, deal-specific 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 offering have different riskRiskRisk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
, reward, and/or maturityMaturity (finance)In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
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 debtHigh-yield debtIn finance, a high-yield bond is a bond that is rated below investment grade...
as their underlying assets. These factors have come to light in the subprime mortgage crisisSubprime mortgage crisisThe U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
. - In case of default, different tranches may have conflicting goals, which can lead to expensive and time-consuming lawsuits, called tranche warfare (punning on trench warfareTrench warfareTrench warfare is a form of occupied fighting lines, consisting largely of trenches, in which troops are largely immune to the enemy's small arms fire and are substantially sheltered from artillery...
). Further, these goals may not be aligned with those of the structure as a whole or of any borrower—in formal language, no agent is acting as a fiduciary. 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 RanieriLewis RanieriLewis S. Ranieri is a former bond trader and former vice chairman of Salomon Brothers. He is considered the "godfather" of mortgage finance for his role in pioneering securitization and mortgage-backed securities...
:
- The cardinal principle in the mortgage crisis is a very old one. You are almost always better off 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 fiduciary. 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 fiduciary.
See also
- Pooled investment
- PrivatizationPrivatizationPrivatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector to the private sector or to private non-profit organizations...
- Thomson Financial League Tables