What is a Tranche?
A tranche identifies a slice of a security (typically a bond or other credit linked security) which is funded by investors who assume different risk levels within the liability structure of a security. This risk can come in the form of a variety of factors; term to maturity, geographic exposure, and even repayment tiers. Tranche's essentially describe the repayment risk that an investor is willing to take; with the higher risk investors receiving higher yields.
Tiered tranches typically repay investors sequentially from highest rated to lowest rated, this is commonly known as "waterfall" since payments flow down from highest to lowest. There are typically three major tranche tiers; Senior and Mezzanine, and Equity. They can be distinguished by their credit ratings; for example, senior tranches are classified as triple A rated debt while mezzanine is AA to BB, and equity is considered "toxic waste" or unrated. In the event of a default, it is highly unlikely that the equity holders will be repaid. In most cases, senior tranches consist of risk averse entities such as pension funds, insurance companies, and conduits.
In the case of certain securities, such as the synthetic CDO, a super senior tranche also exists.
Benefits of Tranches
Without tranching, investors would not be able to expose themselves to different levels of risk; it would be an all or nothing proposition. Tranches allows risky investors to purchase the risk portion of the security while allowing investors looking for safehaven to buy into the highly rated portion of the security.
Disadvantages of Tranches
There are a few which have been brought to light during the credit crisis. First, they are very complex; most investors do not really understand the risks associated with each tranche. Tranches can be tiered, adding more complexity and rules around each possible scenario under worst case assumptions. Again, most investors will not do their due dilligence. We have seen a failure in understanding these tranched structures at the highest levels. Credit agencies like Standard and Poors and Moody's failed to properly account for the massive risks that were inherent in most of these credit linked securities. These agencies were providing triple A ratings to tranches within securities which were very close to defaulting.