A traunch, in the context of mortgage-backed securities (MBS), refers to a specific portion or slice of the overall pool of mortgage
loans that are securitized and sold to investors. These traunches are created to meet the varying risk
and return preferences of different investors. By dividing the pool into multiple traunches, each with its own characteristics, MBS issuers can attract a broader range of investors and optimize the pricing and risk profile of the securities.
When a mortgage lender originates a loan
, it typically holds the loan on its balance sheet
until it is repaid. However, in order to free up capital for further lending, lenders often sell these loans to MBS issuers. The MBS issuer then pools these individual mortgage loans together and creates MBS, which are then sold to investors in the secondary market.
To cater to the diverse investment preferences of investors, MBS issuers divide the pool of mortgage loans into different traunches. Each traunch represents a distinct level of risk and return. The traunches are structured hierarchically, with senior traunches having priority in receiving interest
payments from the underlying mortgage loans, while junior traunches have a lower priority.
The senior traunches, also known as "senior tranches," are considered less risky as they have a higher claim on the cash flows generated by the underlying mortgage loans. Investors in senior traunches receive regular interest payments and have a higher likelihood of receiving their principal back in a timely manner. These traunches typically have a lower yield
compared to junior traunches but offer more stability and lower credit risk.
On the other hand, junior traunches, also known as "subordinate tranches" or "mezzanine tranches," carry higher risk but offer potentially higher returns. Investors in junior traunches have a lower claim on cash flows and are more exposed to losses in case of defaults or delinquencies in the underlying mortgage loans. These traunches have a higher yield to compensate investors for the additional risk they assume.
The creation of traunches allows MBS issuers to tailor the risk and return characteristics of the securities to meet the preferences of different investors. This flexibility attracts a wider range of buyers, including those seeking stable income streams and those willing to take on higher risk for potentially higher returns. It also helps in optimizing the pricing of the MBS, as investors can choose the traunch that aligns with their risk appetite and return expectations.
In summary, traunches in the context of mortgage-backed securities refer to distinct portions or slices of a pool of mortgage loans that are securitized and sold to investors. These traunches offer different levels of risk and return, with senior traunches being less risky but offering lower yields, and junior traunches carrying higher risk but potentially higher returns. The creation of traunches allows MBS issuers to cater to the preferences of different investors and optimize the pricing and risk profile of the securities.