A tranche is a class of claims within a financing structure, with its own contractual rights to payments and allocation of risk. In a securitisation, several tranches can depend on the same asset pool yet experience very different losses. Knowing the pool's loss is therefore only the first step: an investor also needs the rules for their class.
The pool contains the underlying loans or other assets. The tranches are claims funded by, or referencing, that pool. A mezzanine investor does not simply hold a pro-rata share of every outcome for the whole pool. APRA's securitisation glossary distinguishes the underlying pool from classes whose payment priorities create different credit exposures.
Locate the claim in the loss stack
For a simple credit-loss layer, two boundaries identify the tranche:
- Its attachment amount, , is the pool loss that must be absorbed below it before it begins to lose principal.
- Its detachment amount, , is the pool loss at which its entire principal has been lost.
The layer's original principal is . Under strict junior-first loss allocation, its loss for a stipulated cumulative pool principal loss is
Here , , and are amounts in the same currency units. At , the tranche has no loss; loss begins only when . At , it is exhausted. This describes subordination, the protection supplied by claims that absorb losses earlier.
Consider a fictional static pool of USD100 million, represented entirely by first-loss, mezzanine and senior claims of USD10 million, USD20 million and USD70 million. Stipulate one final unrecovered principal loss of USD15 million, absorbed strictly in that order. Exclude interest, fees, reserves, amortisation, prepayment and subsequent recoveries.
The mezzanine class occupies the loss layer from USD10 million to USD30 million. In USD millions,
The first-loss class loses all 10, the mezzanine class loses 5 and the senior class loses zero. Together they absorb the pool loss of 15. Their remaining principal is respectively 0, 15 and 70, totalling 85.
Fictional principal-loss allocation in USD millions. The highlighted point is a stipulated outcome; the curve maps possible loss amounts without assigning them probabilities.
Three percentages, three denominators
The same outcome can be reported as 15% pool loss, a mezzanine loss worth 5% of original pool principal, or 25% loss of mezzanine principal. For the investor in that class, the last denominator measures the fraction of their principal written down:
Attachment and detachment are also commonly quoted as fractions of pool principal. With this example's original pool balance as the fixed denominator, the mezzanine layer is 10%–30%, with width 20 percentage points. Dividing the layer's loss by its width gives the same class-loss fraction: . Mixing an amount such as USD5 million with a fractional width such as 0.20 produces the wrong units. For an actual transaction, check the balance date and contractual or regulatory denominator before interpreting quoted boundaries.
Priority is more than a credit label
A payment waterfall determines how available collections pay fees, interest and principal over time. A loss-allocation rule determines whose claim absorbs a shortfall. They are connected through the deal documents, but the single loss-layer formula above does not calculate a complete payment waterfall. Our lesson on ABS and the securitisation waterfall develops cashflow priorities and credit enhancement beyond this static example; the full lesson requires membership, with a public preview available.
Nor does every use of “tranche” describe a different credit-loss layer. In mortgage structures, classes can differ in when principal is returned and how they bear prepayment risk. The SEC's CMO explanation describes classes with different balances, coupons, prepayment risks and maturities. A class name or maturity date alone does not establish its loss priority.
Finally, the loss curve gives neither a default probability nor a market price. Forecasting tranche losses requires a distribution of pool losses, including recoveries and dependence between borrowers. Valuation additionally needs the timing and terms of payments, discounting and pricing assumptions. A senior designation is a position in a structure; it does not by itself establish a credit rating or guarantee repayment.
Sources
- APRA: APG 120 Securitisation — glossary definitions of pool, securitisation and senior exposure; Australian ADI context.
- SEC Investor.gov: Mortgage-Backed Securities and Collateralized Mortgage Obligations — classes, payment priorities and prepayment risk in US mortgage securities.
- John C. Hull, Options, Futures, and Other Derivatives, 9th Global Edition (Pearson, 2018), §8.1, pp. 208–210 — tranche claims, simplified principal-loss ordering and separate principal and interest waterfalls.