Bond Tranches

A tranche is a portion of a security which investors can buy into. The term is most frequently used in conjunction with securitization and CDOs.

ACDOcontains many hundreds and thousands of mortgages which are all very similar in terms of payment rates, default rates etc. but investors all have different levels of risk aversion, longevity and return requirements. Using tranches allows all investors to gain exposure to the mortgages within aCDO. TheCDOis split up into tranches each with different interest rates, levels of risk and credit ratings.

• Senior– the top tranche of aCDO, rated AAA; pays very low interest rates but is repaid first (i.e. least risk).
• Junior– the middle tranche of aCDO, usually rated around investment grade level; does not get repaid as early as the senior tranche, but not as late as the mezzanine, pays an average level of interest.
• Mezzanine– the bottom tranche of aCDO, rated below investment grade; pays very high interest rates but absorbs any losses before any other tranche, making it the most risky.

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