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Tranche, a French word meaning "portion" is used in finance to describe a security that can be split up into smaller pieces and subsequently sold to investors. Collateralized debt obligations (CDOs) are normally sold as tranches.

Tranches allow for the ability to create one or more classes of securities whose rating is higher than the average rating of the underlying collateral asset pool or to generate rated securities from a pool of unrated assets. This is accomplished through the use of credit support specified within the transaction structure to create securities with different risk-return profiles.

Tranches also allow investors to diversify their portfolio by allowing exposure to asset classes, such as leveraged loans, whose performance across the business cycle may differ from that of other eligible assets.

Tranching, however, makes securities very complex, and less sophisticated investors have a harder time understanding them and thus are less able to make informed investment decisions. The subprime mortgage crisis has also revealed that many tranches were over-rated by ratings agencies, thus causing many investors to underestimate their risks.

In CDOs, tranches are ranked by the seniority of investors’ claims on the instrument’s assets and cash flows. The more senior the creditor, the less risky the investment and hence the less they will be paid in interest. There are no predetermined rules on how many tranches an individual CDO may contain. The minimum is usually three, but there is no maximum.

The most junior tranches within a CDO is the equity piece, sometimes referred to as the ‘first-loss piece’. The first loss/equity tranche is generally unrated and will account for anything for 2 to 15 percent of a CDO’s total capital structure. To compensate for their subordination within the structure, investors in the equity class of CDOs generally look for returns of between 15 and 20 percent.

The most popular CDO tranches are the mezzanine tranches. These tend to have higher returns than similarly-rated assets such as corporate bonds. If there are defaults or the CDO’s collateral otherwise underperforms, the higher risk tranches will be affected first. Senior and mezzanine tranches are generally rated reflecting both the credit quality of the underlying collateral and the level of protection given to a tranche.

The senior tranches, which provide the majority of the funding of the underlying assets, are rated the highest because the smaller subordinate tranches are the first to absorb losses from problems with the underlying assets. To increase returns, a small slice of the bottom level of the senior tranche can be split off and sold. That slice retains its AAA rating but pays out a higher return because its investors would lose money before the remaining AAA tranche above it. The remainder of the senior tranche is called the “super-senior” because selling the extra slice was deemed to have removed the marginal risk that it would suffer any losses.

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