'Tranches' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Tranches refer to a French word that means a portion or a slice. In the world of investing, it relates to securities which may be subdivided into tinier parts and then sold off to various interested investors. These securities typically represent structured financing. Every part of the tranche is a portion of a few correlated securities that specific banks called investment banks offer all at once. Yet each of the tranches comes with its own set of rewards, risks, and maturities.
MBS Mortgage backed securities are often represented in tranches. There are different types of these MBS. One of them is the CMO collateralized mortgage obligation. Such securities will be subdivided up according to their maturity dates. At this point, the offering firm will sell them to investors who buy them according to the maturity date they prefer. Looking at an example helps to clarify the concept as it pertains to CMOs. An investment bank might offer a tranche or several of them made up of mortgages. The maturity dates on these could vary according to twenty year, ten year, five year, two year, and single year maturities. Each of these would offer a range of returns versus risks. Every maturity would be its own tranche in this example.
There are particular reasons why various investors would prefer different types. In one scenario, the investors might require shorter term cash flows yet not wish to have any in the longer term future. Still other investors might wish for longer term cash flow but not need it today. Because of these different needs from investors, investment banks might decide to split up their assets in the CMOs. They could assign them to different parts, or tranches. This way the former investor is able to obtain his initial cash flow from an underlying group of mortgages while the latter investor can obtain the later period cash flows. Thanks to the investment banks forming such tranches, the CMO securities which might not have attracted sufficient investor interest can acquire a new lease on life through a variety of investors with different needs.
Tranches find a great deal of use in numerous mortgage pools which contain many different types of mortgages. There would usually be riskier loans in the pool that came with greater interest rates. At the same time, more conservative loans that come with lower interest rates will be in most pools. Every pool of mortgages will also possess its own maturity dates that bear on the reward to risk ratios. This is why the investment banks create these tranches into smaller pieces which each contain their own particular common set of financial characteristics that appeal to certain investor scenarios. For any investors who desire to put their capital to work in MBOs, they are able to select the specific tranche kind that will best suit their level of risk tolerance as well as their hoped- for return.
Each of the tranches gets its ultimate value from the mortgage pools which underlie them. The investors who purchase these MBOs are allowed to hold them for longer term, smaller gains that come from the interest payments. They might also decide to attempt to sell them early on for a rapid profit. It is also possible to pursue a combination of strategies, trying to obtain slower steady income for a certain amount of time before selling them off at a profit.
The monthly payments come from pieces of the total interest payments mortgage holders make each month (to their mortgage holder) within the given tranche. This is why those investors who purchase them will obtain a monthly cash flow from the specific MBO tranche in which they invest, so long as they hold on to the tranche.