Using tranches is a good way to move the risk of investments and prepayment penalties, but should you rely on them? The simple answer is no, you shouldn’t rely on them entirely. However, that doesn’t mean that you should shy away from them altogether. By knowing the risk of tranches, you can smartly invest and know what you’re committing to. Here what you need to remember:
Tranches are Inflexible
While tranches are generally a safe investing option, you shouldn’t put all your eggs into one basket, so to speak. For example, tranches tend to be inflexible, so different classes of tranches don’t work well together. That means that a schedule bond tranche and a sequential tranche have different goals and ways they are paid off.
Tranches Affect All Parties
If the borrower of the home you’re investing in defaults, then you will lose what money you put towards that investment. In addition, every other party involved is also affected negatively. If this situation occurs, then investors in the tranches with different goals can result in what is known as tranche warfare.
Tranches Can Complicate Deals
While tranches are useful in creating different classes of securities, they can also make deals more complicated. Meaning, detailed specifics must be documented to make sure that the desired characteristics will be met. In addition, investors who are new to the idea of tranches can have a difficult time understanding them and how to make an informed investing decision.
Always Research Tranches Before You Invest
Before you invest in a tranche, research the pros and cons of each. That way, you can make an educated decision about what tranche type is best for you to invest in. Since tranches are “slices” of structured bonds, their risks can be downplayed by banks. Such falsification is what helped contribute to the 2007 credit market crash.