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🔵 TRANCHES IN MORTGAGE-BACKED SECURITIES
▶️ A tranche is a common financial structure for securitized debt products, such as a collateralized debt obligation (CDO), which pools together a collection of cash flow-generating assets—such as mortgages, bonds, and loans—or a mortgage-backed security. An MBS is made of multiple mortgage pools that have a wide variety of loans, from safe loans with lower interest rates to risky loans with higher rates. Each specific mortgage pool has its own time to maturity, which factors into the risk and reward benefits. Therefore, tranches are made to divide up the different mortgage profiles into slices that have financial terms suitable for specific investors.
▶️ For example, a collateralized mortgage obligation (CMO) offering a partitioned mortgage-backed securities portfolio might have mortgage tranches with one-year, two-year, five-year and 20-year maturities, all with varying yields. If an investor wants to buy a MBS, they can choose the tranche type most applicable to their appetite for return and aversion to risk. A Z tranche is the lowest-ranked tranche of a CMO in terms of seniority. Its owners are not entitled to any coupon payments, receiving no cash flow from underlying mortgages until the more senior tranches are retired, or paid off.
▶️ Investors receive monthly cash flow based on the MBS tranche in which they invested. They can either try to sell it and make a quick profit or hold onto it and realize small but long-term gains in the form of interest payments. These monthly payments are bits and pieces of all the interest payments made by homeowners whose mortgage is included in a specific MBS.
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🔵 WHAT ARE TRANCHES❓
▶️ Tranches are segments created from a pool of securities—usually debt instruments such as bonds or mortgages—that are divided up by risk, time to maturity, or other characteristics in order to be marketable to different investors. Each portion or tranche of a securitized or structured product is one of several related securities offered at the same time, but with varying risks, rewards and maturities to appeal to a diverse range of investors.
▶️ Tranche is a French word meaning slice or portion.
▶️ They are commonly found in mortgage-backed securities (MBS) or asset-backed securities (ABS).
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🔵 HOW DOES ASSET SECURITIZATION WORK❓
▶️ Asset securitization begins when a lender (or any company with loans) or a firm with income-producing assets earmarks a bunch of these assets and then arranges to sell the lot to an investment bank or other financial institution. This institution often pools these assets with comparable ones from other sellers, then establishes a special-purpose vehicle (SPV)—an entity set up specifically to acquire the assets, package them, and issue them as a single security.
▶️ The issuer then sells these securities to investors, usually institutional investors (hedge funds, mutual funds, pension plans, etc.). The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the portfolio of assets.
▶️ Sometimes the issuer divides the original asset portfolio into slices, called tranches. Each tranche is sold separately and bears a different degree of risk, indicated by a different credit rating.
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🔵 WHAT IS ASSET BACKING❓
▶️ Asset backing refers to the total value of a company's shares, in relation to its assets. Specifically, it refers to the total value of all the assets that a company has, divided by the number of outstanding shares that the company has issued.
▶️ In terms of investments, asset backing refers to a security whose value derives from a single asset or a pool of assets; these holdings act as collateral for the security—"backing" it, in effect.
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