Tranches

Tranches are legally defined segments of a securitization, each with its own payment priority, maturity expectations, and loss absorption order. In a typical CMO structure, senior tranches (like A1, A2) receive payments first and only absorb losses after junior layers are exhausted. This hierarchy makes seniors behave like short-duration, high-quality fixed income, while mezzanine (B, C) and equity (Z, BPO) tranches trade with higher yield but greater vulnerability to prepayment volatility or credit losses. Equity tranches, for instance, may receive only residual cash flows after all seniors are paid in full.

Prepayment risk is intentionally uneven across tranches: some—like planned amortization classes (PACs)—use collars to protect against both early and late prepayments within a band, while others (TACs, support tranches) absorb the brunt of extension or contraction risk. During falling rate environments, seniors with high coupons may shorten dramatically as borrowers refinance, but PAC tranches are designed to maintain target schedules by shifting prepayment impact to support tranches. Understanding which tranche absorbs what risk is essential for matching duration and volatility profiles to investment objectives.

Credit risk also layers through the structure: in non-agency deals, losses first eat into equity tranches, then mezzanine, and only after those are fully written down do seniors see any impact. This allows seniors to maintain AAA ratings even with high default rates in the underlying pool—if losses stay below the equity cushion. Investors assess tranche loss absorption capacity using stress models that simulate housing price declines, unemployment spikes, or interest rate shifts to see how far down the waterfall losses would travel before hitting their tranche.