Tranches

Tranche is a term used to describe a portion or slice of a larger financial arrangement, asset pool, or program. The word comes from French tranche, meaning a slice, and is used to identify segments that have different rights, risk profiles, or timing of payments.

In securitization, a pool of assets such as mortgages or loans is financed by issuing several tranches through a special purpose vehicle. Each tranche has its own level of credit enhancement, interest rate, and priority of repayment. A cash-flow waterfall determines how proceeds from the pool are distributed, with senior tranches paid first, followed by mezzanine and equity tranches. If defaults occur, losses are absorbed from the bottom up, so the more junior tranches bear the first losses but offer higher potential yields.

Tranches are also used in lending facilities and project finance to tailor funding to different stages or risk appetites. In budgeting or grant programs, disbursements may be released in tranches as milestones are met or conditions are satisfied.

Important considerations include the fact that tranche structures can affect liquidity, valuation, and regulatory capital treatment. Ratings agencies assess each tranche separately, reflecting its risk and seniority. Investors trade off safety and yield by choosing among tranches with varying levels of protection and exposure to losses.