Tranche

What Is a Tranche?

A tranche is one of several separate pieces created from a single financial offering, such as a bond issue, a pool of loans, or a structured investment product. The word comes from French and means "slice." Each slice is sold to investors with its own terms, including when it gets paid, how much it pays, and how much risk it carries.

How Tranches Work

Issuers divide a deal into tranches so that different investors can choose the level of risk they are willing to accept. The cash flows from the underlying assets, such as mortgage payments or loan interest, are usually distributed in a fixed order, often called a payment waterfall.

• Senior tranches are paid first. They usually carry lower risk and lower expected returns.
• Mezzanine tranches sit in the middle. They are paid after senior tranches and carry moderate risk.
• Junior or residual tranches are paid last. They absorb losses first and typically offer higher potential returns to compensate.

Tranches can also differ by maturity. In a sequential-pay structure, early principal payments go to the first tranche until it is fully repaid, then move on to the next.

An Illustration

Suppose a pool of loans is divided into three tranches. If some borrowers default, the losses hit the junior tranche first. Only after that tranche is exhausted do losses reach the mezzanine tranche, and the senior tranche is protected the longest. This is the basic idea behind subordination, the practice of ranking one class of claims below another.

Why Tranches Matter to Investors

Tranches let investors match a specific slice to their goals, but they also add complexity. Two tranches from the same deal can behave very differently, so investors often read the offering documents closely to understand the priority rules.

Tranches carry their own risks. For example, a credit rating may be assigned to each tranche separately, and ratings reflect opinions about default risk, not guaranteed outcomes. In mortgage-based structures, early repayment of the underlying loans can change the timing of payments, which is known as prepayment risk.