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Bond Tranches

Category — General Notions
Bond tranches are typically portions of mortgage-backed securities that are offered at the same time, with varying levels of risk, rewards, and maturities. Such tranches are paid sequentially, starting with the senior tranches and ending with the junior tranches. Senior tranches have a higher bond credit rating than junior tranches (although these ratings may change after debt issuance). The holders of the senior tranche have a priority right to receive payments in comparison with the holders of the junior tranches. In other words, the younger the tranche, the higher its risk and, hence, the associated return. Thus, in the event of defaults on mortgage loans, it is the holders of junior tranches who will suffer in the first place.

The main advantage of bond tranches is that they allow the creation of higher-rated securities than their pool of underlying assets. This is because the higher-rated senior tranches are protected from the default risk of the underlying asset pool (as losses will be absorbed by the junior tranches). In addition, tranches allow investors to tailor their investment strategies to suit their own needs. For example, investors, depending on their own preferences, can choose tranches with long or short maturities.
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