A term used in the investment world to describe a security that can be broken down into smaller parts and then sold to investors.
Active Tranche Details
An active tranche is a group of securities divided and grouped based on different characteristics before being marketed to investors. They can vary in terms of maturity, credit ratings, yields, or interest rates. Loans, bonds, mortgages, and insurance plans are examples of financial instruments divided into active tranches.
In the credit and debt markets, a mechanism known as securitization splits up different types of debt instruments and packages them into funds. Investors who want to collect the debt’s interest rate then buy them. Investment bankers may manage loans with similar characteristics that cater to particular investors into a single basket. An investor can be offered many loan baskets with varying interest rates. For example, investors who want to collect a 6% yield should go for that particular active tranche of loans.
Investors expect fair compensation–a higher yield–to keep an investment for a more extended period or take on more risk than lower-rate investments. An active tranche of debt securities can only have different credit scores, but they may also have different payout situations if the issuer defaults. For instance, senior active tranches usually have higher credit ratings and are paid first in bankruptcy or liquidation of the issuer.
Example of an Active Tranche
During the financial crisis of 2007-2008, a variety of debt instruments, including mortgage loans, became common. Financial companies bundled mortgage loan active tranches into different funds, such as mortgage-backed securities—these companies sold to investors seeking interest income. However, they didn’t adequately disclose many of the credit risks—or the possibility of loss—associated with the loans inside these funds, and investors were unaware of the funds’ holdings. Many of the loans turned out to be much riskier than they had seemed to be.
Credit agencies had given the funds containing subprime mortgages a far higher credit rating in some cases. Subprime mortgages target higher-risk borrowers with a limited or negative credit history. Some funds also held assets that were not considered investment-grade, such as junk bonds.
With the breakdown of the U.S. housing market in 2008, the financial crisis reached its pinnacle. Many subprime mortgage loans defaulted or didn’t make payment. As a result, those who had put money into these funds, which included mortgage loan active tranches, suffered substantial losses.
Active Tranche vs. Mortgage-Backed Security
Similar to an active tranche, mortgage-backed securities also combine investments. Mortgage-backed securities (MBS) are a set of mortgage loans bundled together and sold to investors as a package. MBS uses active tranches in the Mortgage Market Tranches, including collateralized mortgage obligations (CMO). These securities may be partitioned based on their maturities and credit scores to cater to various investors.
MBS is a form of investment vehicle that consists of a collection of mortgages that have been combined and sold to investors. In the sense that it pays an interest rate, mortgage-backed securities are equivalent to a bond. A bond’s rate, on the other hand, is usually based on a single debt instrument.
The MBS pays a rate based on the interest rates of a pool of home loans in the fund, minus any fees or operating costs. A MBS is an asset-backed security, which means that the assets backing the loans are just as secure as the loans themselves. Investors can acquire a tranche of home loans via an MBS that fits their preferred time, interest rate, and risk tolerance, depending on their preferences.