Bond market Fixed income Corporate bond Government bond Municipal bond Bond valuation High-yield debt Stock market Stock Preferred stock Common stock Stock exchange Foreign exchange market Retail forex Derivative market Credit derivative Hybrid security Options Futures Forwards Swaps Other Markets Commodity market OTC market Real estate market Spot market Finance series Financial market Financial market participants Corporate finance Personal finance Public finance Banks and Banking Financial regulation In structured finance, the word tranche (misspelled as traunch or traunche) refers to one of several related securitized bonds offered as part of the same deal. The word tranche is French for slice, section, series, or portion; in the financial sense of the word, each bond is a slice of the deal's risk. The legal documents (see indenture) usually refer to the tranches as "classes" of notes identified by letter (e.g. the Class A, Class B, Class C securities).
How tranching works
A bank transfers risk in its loan portfolio by entering into a default swap with a "ring-fenced" SPV ("Special Purpose Vehicle")
The SPV buys gilts (UK government bonds)
The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
- Tranche A absorbs the first 25% of losses on the portfolio
Tranche B absorbs the next 25% of losses
Tranche C the next 25%
Tranche D the final 25%
Tranches B, C and D are sold to outside investors
Tranche A is bought by bank itself Benefits
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 other 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 risk, reward, and/or maturity characteristics.
Tranching has largely led to the understatement of the risks embedded in high-yield debt and asset-backed securities backing the structured products. These risks have surfaced recently in the light of the subprime meltdown. See also
"Tranche" is also the name of the ProteomeCommons.org file sharing network for scientific data (http://tranche.proteomecommons.org). The name is used to refer to how Tranche works: many research groups share a portion or slice of the responsibility for sharing public access scientific data sets.