In the world of finance and investments, a tranche usually refers to a specific part of a larger transaction. The word tranche is actually French, and is translated into English as “portion” or “part.” Tranches are often used in such larger transactions as collateralized mortgage obligations as a means of assuring investors of some sort of regularity in the payment of premiums on the investment.
To understand the function of the tranche, it is helpful to see a large transaction as containing a subset of components, with investors funding the activity a little at a time. Investors in these types of transactions rarely pay a lump sum in return for their share of investment in the security. Instead, they will pay in increments that are sometimes referred to as staged investments or tranches.
The purchase and resale of bank instruments by a trading group is an excellent example of how a tranche works. The instruments are purchased in blocks, with commitments to eventually purchase all outstanding blocks named within the contract. The purchase of the initial block may be only a fraction of the total cost for the contracted amount of shares, but other blocks will be purchase at specified times for the duration of the contract. At the same time, the purchaser of the blocks can be reselling the bank instruments, covering the purchase price of the block and usually making a profit as well. This allows the purchaser to cover the cost of the next scheduled purchase of a tranche, and in turn repeating the sale process. Following this pattern of structured finance benefits just about everyone involved.
Securitized bonds are often structured with the use of a tranche approach. The securitized bond issue may be of such a size that the idea of buying and selling in portions is not only workable, but also favorable. When structured properly, the end result can be profitable for both the issuers of the bonds as well as the entities that purchase and resell the portions of the bond.