In investing, “tranche” refers to a security that can be sold to investors by dividing it into more manageable accounts. In commercial real estate, tranches relate to commercial mortgage-backed securities (CMBS), which can be pooled by credit rating or maturities to sell to buyers with different needs.
The Definition of “Tranche”
“Tranche” comes from the French word meaning “portion.” These securities are divided by certain characteristics — including credit scores, yields, interest rates or maturities — before being sold to investors. Several financial instruments could be included in a tranche, including bonds, loans, insurance policies and mortgages.
Therefore, tranches relate directly to securitization, which divides debt and packages it into separate funds for investors interested in earning interest to purchase and secure. For example, investment bankers may group loans into one portion or “basket” based on shared characteristics and sell them to investors, often at different interest rates.
Depending on the percent yield an investor wants to earn, they can opt for different tranches of loans. Each would have its own credit score and maturity date, which changes the risks (and therefore, the profits) associated with each group of loans.
Therefore, a basket of loans with a higher percentage yield would have a higher risk of default or a longer maturity date. To take on this risk, investors demand a higher return, hence the higher rate.
Tranches can also be separated into “senior” and “junior” tranches, which changes the payout scenario in the event that the issuer defaults on the loan. Senior tranches usually payout sooner and have better credit ratings.
Tranches in Commercial Real Estate
Tranches apply to commercial real estate in the form of commercial mortgage-backed securities, which can be separated by credit rating or maturity to sell to buyers with specific needs. These include collateralized mortgage obligations (CMO).
These investments refer to a basket of mortgages that pay interest rates based on the total home loans in the fund. Unlike a bond, which pays interest on the holder’s fixed payments, mortgage-backed securities are backed by assets. The fund’s operation costs are subtracted as fees.
Commercial mortgage-backed securities are supported by the holder’s commercial real estate, rather than more common collateral seen in residential real estate loans.
Tranches in Popular Discourse
Tranches were not well-known until the financial crisis of 2007-2008 when tranches of mortgage loans were sold in packages, including mortgage-backed securities, to investors seeking interest income.
The loans proved riskier than they first appeared, however, with many of them containing borrowers with low or zero credit history. Any of these “subprime mortgages” — those lent by high-risk borrowers who lacked investment-worthy collateral — defaulted in 2008 when the housing market crashed.
This is why tranches are sometimes considered risky investments. However, commercial mortgage-backed securities are generally safer than residential securities due to the fact that they work on a fixed term. Junior tranches are less secure and pay higher interest rates as a result. So long as the housing market does not default, investors who have bought into tranches of mortgage loans should not expect significant losses.