Tranches

Tranches can make or break your investment. It is important that you know what they are and how they influence your "slice of the deal" because they do make up the overall capital structure of your bond investments.

So the first term you need to know is "tranche." A tranche is simply bonds that offer different degrees of risk for investors. Accompanying the term is CMO, which is collateralized mortgage obligation since bonds are comprised of mortgages that have been pooled together into an investment that pays investors interest.

What you want when it comes to tranches is active tranches, which are those that are actively paying their investors a return on their investment. The idea is for you to yield the best returns possible in order to make the investment deal a worthwhile one.

How Tranches Work

Tranches make up the capital structure of a financial deal. They pay from the most senior of tranches to those considered to be at the bottom of the list. The more senior tranches are usually those that have excellent bond ratings. The bond ratings are basically credit ratings. This means that the bond issuer pays their premiums and interest on time according to their predetermined schedule.

The rating system that is used to rate these bonds are the Moody Bond Ratings with Aaa being the highest rating and D being the lowest. The ratings can fluctuate, however, based upon debt. Even senior tranches can find themselves falling below the highest rating, yet rising back to the top at a later date. However, where the tranche stands depends on which gets payment first, thus the maturity date can be affected.

Maturity

As a bond works toward maturity, there are certain things that happen. Yes, the bond gains interest as it goes and the accrued interest is then paid on the maturity date. A Z-tranche may be used to speed up the maturity process of senior tranches. Basically, the payment that was supposed to go to the Z-tranche is sent elsewhere to the priority tranches. Those that worry about taking their accrued interest and reinvesting it into the bond may find this method to be quite useful to them. They feel that their risk is lowered.

If nothing is done to speed up maturity, the bond will mature like normal and the accrued interest will be paid as usual.

Tranche Priorities

There is what is called an asset pool and this asset pool most likely consists of mortgages. Those tranches that contain the first lien on that pool are typically the safest investments and hold the senior position. The "junior notes" are those that contain a second lien or no lien. Those seeking high risk investments that yield higher returns tend to be the investors for these tranches.

There are a number of benefits to tranches that the investor can take advantage of. Those benefits include the ability to invest in higher rated securities that yield little risk and generous returns and the ability of tranches to change position in order to better avoid loss. The disadvantages include the fact that deals can be more complex. This can result in beginner investors to become confused, but everyone has to start somewhere.

If you find that you are confused by the concept of tranches and how they can improve your investments, a financial advisor can help you. They can educate you and help you to find the best investments. By you having a better understanding of tranches and the overall market, you and your financial advisor can work together to make the best investment decisions for you.

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