Tranches are a way to divide a larger pool of assets, such as bonds or mortgages, into smaller, more manageable portions. The term is often used in the context of securitization, where a group of assets are packaged together and sold to investors as securities.Tranches are usually created based on the creditworthiness of the underlying assets, with the highest-rated tranche (called the "senior tranche") receiving the first priority of payments, and the lowest-rated tranche (called the "equity tranche") receiving the last priority of payments.For example, a bank may have a pool of mortgages with varying creditworthiness. The bank could divide the mortgages into tranches, with the first tranche consisting of the mortgages with the best credit scores, the second tranche consisting of the mortgages with slightly lower credit scores, and so on. These tranches could then be sold to investors as securities, with the investors in the first tranche having the first priority of payment and the lowest risk, and the investors in the last tranche having the last priority of payment and the highest risk.Another example is Collateralized Debt Obligations (CDOs) which are securities that pay investors based on the cash flow generated by a pool of debt securities. Tranches are created on the basis of credit risk, with the highest-rated tranche being the safest, and the lowest-rated tranche being the riskiest.In summary, Tranches are a way of dividing a larger pool of assets into smaller parts, usually based on creditworthiness or risk. They are used to offer investors different levels of risk and return, and are often used in securitization and structured finance.
