Lucrative investment opportunities are everywhere, but some investments can generate an exceptionally high ROI. One of those high-paying investment opportunities is a tranche.
A tranche investment is a small slice of a collection of securities. Tranche securities are split up according to certain characteristics and sold to different investors. Within a tranche, investments carry varying degrees of risk. The variation is what makes the tranches more attractive to a wider variety of investors.
Slicing up the investments according to different characteristics increases the marketability of the tranche. For example, mortgage-backed securities (MBS) are often bundled up into tranches and sold to investors with different cash flow needs.
With regard to mortgages, a tranche consisting of collateralized mortgage obligations (CMOs) might be partitioned so that one investor receives early cash flows while another investor receives the latter cash flows. Both investors have different needs yet can invest in the same group of securities.
The potential reward for tranche investments
Investing in tranches comes with the potential for some pretty big rewards. Tranche investors get monthly cash flow and can either sell their investment for immediate profit or hang onto it for smaller, long-term gains. Experienced investors can generate substantial cash flow from investing in tranches.
Investing in mortgage backed securities has potential
Of all the investments bundled into tranches, residential mortgage backed securities (RMBS) are one of the best options for investors. These debt-based securities consist of a pool of residential mortgages.
Typically, banks and other financial institutions buy RMBS to get funding for their own mortgage lending needs. However, they’re also available to investors who want access to the residential property mortgage market. Investors purchase these debt securities from lenders in order to earn interest on the entire pool.
RMBS are a low-risk investment for investors in all parts of the world. In Australia, for example, nobody has ever lost a single dollar of capital with a prime RMBS default.
How investors get paid from RMBS investments
Generally speaking, the payments from RMBS investments are straightforward: when the home loans are paid, investors get paid. However, the amount of money investors receive depends on the circumstances surrounding the individual payments. Those details can be extremely complex.
As Firstmac explains, investors choose tranches based on their investment goals and investment risk. The risk of each investment is essentially the borrower’s credit rating. Higher tranches earn less interest, but are insulated from the risk of default since losses are absorbed by the lower tranches. Lower tranches earn more interest because they are a riskier investment.
Experienced investors don’t mind the risk
There will always be risk involved in any worthwhile investment; that’s what makes investing attractive. Although some tranches carry unpredictable risk, there is a strategy involved in tranche investing. For instance, investors who want long-term cash flow invest in tranches that take longer to mature. Investors who need immediate cash flow invest in tranches that mature quickly.
With a smart investment strategy, the risk is small compared to the potential for reward. Experienced investors will already have a diverse portfolio of investments in case a new tranche investment fails to become profitable.
RMBS investments make a good complement to other assets
While investing in RMBS tranches can create a steady flow of cash, it’s best to use these investments as a complement to other fixed-income assets. RMBS investments diversify real estate risk, but require an experienced investor to scrutinize the terms to accurately identify profitability.
One word of caution to new debt investors
Investing in debt can be extremely lucrative, but new investors should always consult a professional before diving in. Since each tranche is suitable for different goals, it’s imperative for investors to know which investments are suitable.
Another potential pitfall with investing in tranches is that credit rating agencies sometimes rate tranches higher than deserved. This mistake can create hidden and unnecessary risk for investors.
Unfortunately, this type of mislabeling contributed to the 2007 financial crisis. Normally, tranches don’t contain sub-prime mortgages because they’re not investment grade. In 2007, however, investors discovered that sub-prime mortgages were contained in tranches and were inaccurately rated as high-grade assets. The banks had been approving loans for people who couldn’t afford their payments and were selling those loans to investors as if they were high grade.
New to tranches? You’re on the right track
If you’re considering investing in a tranche, you’re on the right track. However, if you’ve never invested in a tranche, consult with a financial expert before making your first move.