Tranched securities

Tranched securities are generally rated by a rating agency, with the rating reflecting both the credit quality of the underlying assets as well as any measures put in place to reduce credit risk, known as credit enhancement. 

All classes of a single CMO receive an equal share of the interest payments it is the principal repayments received that differ. Consider an issue with a nominal value of 100 million, 60 million of which is allocated to the class A tranche, 25 million to the class B, and the rest to class C. Holders of class A bonds receive all the principal repayments until the bonds retire, after which class B holders get all the repayments, and so on. The class A bonds thus have the shortest maturity and the highest credit rating, and the class C bonds the longest and usually the lowest. A level of uncertainty is still associated with the maturity of each bond, but it is lower than that associated with a pass-through security. CMOs are discussed in more depth below. 

In the PAC structure, the uncertainty of principal payments is directed to another class of security, i.e., another tranche in the CMO, known as the companion, or support, class. When prepayment rates are high, companion issues support the main PACs by absorbing any principal prepayments that are in excess of the PAC schedule when the rate falls, the companion amortization is delayed if principal prepayments are not sufflcient to reach the minimum stipulated by the PAC band. Accordingly, when prepayment rates are high, the companions average life shortens when rates are low, their average life lengthens. Within the set of PACs and the set of companions, the principal cash flows can be allotted sequentially, as in the sequential-pay structure. 

The tranche structure for ACE Securities HELT series 2004 is shown in FIGURE 14.8. The transaction was undertaken to provide a diversified funding source for Fremont, with a size of more than 751 million. 

Notes issued in synthetic structures are organized by tranche. With the proceeds from the notes it issues to investors, the SPV purchases high-quality (AAA) liquid securities—for example, U.S. Treasuries, bank asset-backed paper such as credit card ABS, and German bonds, such as Pfandbriefe —to serve as collateral. This collateral will generate LIBOR-related interest and principal cash flows that the SPV passes on to the investors together with the swap premium, which creates an additional credit spread on the notes. The cash flows from the collateral may not match the payments due on the issued notes—for example, the bonds used as collateral may pay a flxed rate and the issued notes a floating one. To remedy this, the... 

Asset-backed bonds, for instance, are issued in a number of tranches— related securities from the same issuer—each of which pays a different fixed or floating coupon. Nevertheless, this is still commonly referred to as the fixed-income market. 

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