Tranching investment strategy refers to dividing investment products into different tranches to better manage risks and returns. It is commonly used in structured finance products like mortgage-backed securities, collateralized debt obligations, and hedge funds. By creating senior and junior tranches with different risk-return profiles, issuers can appeal to investors with varying risk appetites. This article will introduce the rationale, structure, and risks of tranching in detail. We’ll also evaluate whether tranching is an effective investment strategy to manage risks.
Tranching lowers funding costs by appealing to diverse investors
Tranching allows issuers to access a wider investor base and lower overall funding costs. By creating tranches with seniority levels, issuers can attract conservative investors to the senior tranches which have higher credit quality and lower yields. More risk-tolerant investors are drawn to junior tranches with higher yields and subordination risk. Overall, tranching creates a menu of risk-return options to broaden the investor pool. A larger investor base drives more demand for the investment product, allowing issuers to lower funding costs.
Tranching transfers risks to junior tranches
Tranching investment products transfers risks disproportionately onto junior tranches. Senior tranches are structured to have priority claims on cash flows and liquidation proceeds. Junior tranches act as the first loss position and their investors face heightened default risks. This mechanism allows senior tranche investors to gain exposure to the asset pool’s returns while being partially insulated from downside risks. However, tranching does not eliminate risks but rather transfers them onto other parties.
Tranching facilitated excess risk-taking prior to the 2008 financial crisis
In the years leading to the 2008 financial crisis, tranching was used extensively to repackage subprime mortgage securities into collateralized debt obligations (CDOs). By creating AAA-rated senior tranches, issuers convinced investors that these CDOs were safe investments with high returns. However, the underlying assets were still exposed to significant default risks that materialized when US housing prices fell. Tranching facilitated the rapid growth of risky lending by masking the true risks of mortgage-relatedstructured products. Many institutions took on excessive exposures to senior tranches without appreciating the risks.
Evaluate risks beyond ratings when investing in tranched products
The 2008 financial crisis revealed that ratings failed to reflect the risks of senior tranches in many structured products. When selecting tranched investments, investors should conduct thorough due diligence into the quality of the underlying assets. It is also important to assess the correlation of defaults across the asset pool, which greatly impacts the riskiness of senior tranches. Lastly, evaluate the incentives of issuers and avoid products where asset selection may be distorted by short-term goals.
Tranching investment products allows issuers to lower funding costs by appealing to diverse investor bases. However, tranching also facilitates risk concentration and complacency. Investors should evaluate tranched products based on a prudent assessment of underlying asset risks rather than rely blindly on ratings or seniority claims.