What are Tranches?
For all Asset-Backed Securities (ABS), Tranche is a critical aspect of the securitization process. In the securitisation process, ABS has category into investable tranches. These divisions are beneficial to distribute credit risk and assist rating agencies in identifying the risk associated with every Tranche.
These define into junior, mezzanine, and senior tranches. Most junior parts offer a high-interest rate but only receive cash flows after paying all other divisions. For this reason, most junior Tranche refers to the equity tranche or even toxic waste. Above the equity tranche is the mezzanine tranches, which receive payment before the junior tranches. The highest-rated Tranche has another name, the super senior Tranche (often rated AAA). It is the safest Tranche and the first Tranche to pay; however, it pays investors a relatively low-interest rate.
Role of Tranches in the securitization
These play an essential role in the securitization process by enabling investors to invest in a specific level of risk and reward. Structuring involves dividing the underlying asset pool into separate pieces, each with its own level of risk and return. Institutional investors like insurance companies and pension funds typically purchase the senior tranches, which are the safest and have the lowest yield. While hedge funds and other investors with a higher tolerance for risk typically purchase the junior tranches, which are riskier and offer higher yields.
In addition to providing investors with a range of investment options. They also help to mitigate the risks associated with securitization. It is possible to lower the total risk of the ABS by segmenting the assets into a number of different tranches. This is due to the fact that the senior tranches receive their payments first, while the junior tranches are responsible for covering any losses. This ensures that the potential for default or loss is not centred on a single location but rather is dispersed among the many tranches.
However, it is worth noting that the tranche structure is not foolproof. And in times of financial distress, even the senior tranches can suffer losses. This was evidenced in the 2008 financial crisis, where even AAA-rated senior portions suffered significant losses.
They provide investors with a valuable tool for managing risk and reward in securitized assets. However, it is essential to understand the underlying risks and perform proper due diligence before investing in any tranche.