In structured finance , a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk . Transaction documentation (see indenture ) usually defines the tranches as different "classes" of notes, each identified by letter (e.g., the Class A, Class B, Class C securities) with different bond credit ratings .
46-571: The word tranche means a division or portion of a pool or whole and is derived from the French for 'slice', 'section', 'series', or 'portion', and is also a cognate of the English ' trench ' ('ditch'). The term tranche is used in fields of finance other than structured finance (such as in straight lending, where multi-tranche loans are commonplace), but the term's use in structured finance may be singled out as particularly important. Use of "tranche" as
92-521: A dynamic structure that approximates reality. A similar type of research is performed under the guise of credit risk research in which the modeling of the likelihood of default and its pricing is undertaken under different assumptions about investors and about the incentives of management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju, Leland (1998) and Hennessy and Whited (2004). In addition to firm-specific characteristics, researchers find macroeconomic conditions have
138-403: A foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fiduciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as
184-845: A manner compatible with their growth types. As economic and market conditions improve, low growth type firms are keener to issue new debt than equity, whereas high growth type firms are least likely to issue debt and keenest to issue equity. Distinct growth types are persistent. Consistent with a generalized Myers–Majluf framework, growth type compatibility enables distinct growth types and hence specifications of market imperfection or informational environments to persist, generating capital structure persistence. A capital structure arbitrageur seeks to profit from differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds, and convertible bonds . The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of
230-616: A material impact on capital structure choice. Korajczyk, Lucas , and McDonald (1990) provide evidence of equity issues cluster following a run-up in the equity market. Korajczyk and Levy (2003) find that target leverage is counter-cyclical for unconstrained firms, but pro-cyclical for firms that are constrained; macroeconomic conditions are significant for issue choice for firms that can time their issue choice to coincide with periods of favorable macroeconomic conditions, while constrained firms cannot. Levy and Hennessy (2007) highlight that trade-offs between agency problems and risk sharing vary over
276-403: A recognition of how outsiders view the strength of the firm's financial position. Key considerations include maintaining the firm's credit rating at a level where it can attract new external funds on reasonable terms, and maintaining a stable dividend policy and good earnings record. Once management has decided how much debt should be used in the capital structure, decisions must be made as to
322-416: A second lien or no lien are often referred to as "junior notes". These are more risky investments because they are not secured by specific assets. The natural buyers of these securities tend to be hedge funds and other investors seeking higher risk/return profiles. "Market information also suggests that the more junior tranches of structured products are often bought by specialist credit investors, while
368-441: A verb is limited almost exclusively to this field. All the tranches together make up what is referred to as the deal's capital structure or liability structure. They are generally paid sequentially from the most senior to most subordinate (and generally unsecured), although certain tranches with the same security may be paid pari passu . The more senior rated tranches generally have higher bond credit ratings (ratings) than
414-400: Is a negative relationship in the market between companies' relative price volatilities and their leverage. This contradicts Hamada who used the work of Modigliani and Miller to derive a positive relationship between these two variables. Three types of agency costs can help explain the relevance of capital structure. An active area of research in finance is that which tries to translate
460-429: Is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fiduciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in
506-429: Is an advantage to financing with debt, namely, the tax benefits of debt and that there is a cost of financing with debt the bankruptcy costs and the financial distress costs of debt. This theory also refers to the idea that a company chooses how much equity finance and how much debt finance to use by considering both costs and benefits. The marginal benefit of further increases in debt declines as debt increases, while
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#1732843972074552-770: Is an important issue in setting rates charged to customers by regulated utilities in the United States. Ratemaking practice in the U.S. holds that rates paid by a utility's customers should be set at a level which assures that the company can provide reliable service at reasonable cost. The cost of capital is among the costs a utility must be allowed to recover from customers, and depends on the company's capital structure. The utility company may choose whatever capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes. The Modigliani–Miller theorem , proposed by Franco Modigliani and Merton Miller in 1958, forms
598-461: Is because the interest paid by the firm on the debt is tax-deductible. The reduction in taxes permits more of the company's operating income to flow through to investors. The related increase in earnings per share is called financial leverage or gearing in the United Kingdom and Australia. Financial leverage can be beneficial when the business is expanding and profitable, but it is detrimental when
644-461: Is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the Modigliani–Miller theorem. Trade-off theory of capital structure allows bankruptcy cost to exist as an offset to the benefit of using debt as tax shield. It states that there
690-417: Is not normative i.e. and does not state that management should maximize EPS, it simply hypothesizes they do. The 1982 SEC rule 10b-18 allowed public companies open-market repurchases of their own stock and made it easier to manipulate capital structure. This hypothesis leads to a larger number of testable predictions. First, it has been deducted that market average earnings yield will be in equilibrium with
736-461: Is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory has been popularized by Myers (1984) when he argued that equity is a less preferred means to raise capital, because when managers (who are assumed to know better about true condition of
782-515: The marginal cost increases, so that a firm optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in debt-to-equity ratios between industries, but it doesn't explain differences within the same industry. Pecking order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to
828-668: The waterfall (because the monies flow down). Tranches with a first lien on the assets of the asset pool are referred to as senior tranches and are generally safer investments. Typical investors of these types of securities tend to be conduits , insurance companies , pension funds and other risk averse investors . Tranches with either a second lien or no lien are often referred to as "junior notes". These are more risky investments because they are not secured by specific assets. The natural buyers of these securities tend to be hedge funds and other investors seeking higher risk/return profiles. "Market information also suggests that
874-501: The Class A, Class B, Class C securities) with different bond credit ratings . The word tranche means a division or portion of a pool or whole and is derived from the French for 'slice', 'section', 'series', or 'portion', and is also a cognate of the English ' trench ' ('ditch'). The term tranche is used in fields of finance other than structured finance (such as in straight lending, where multi-tranche loans are commonplace), but
920-465: The amount of debt in a company's capital structure. The Miller and Modigliani theorem argues that the market value of a firm is unaffected by a change in its capital structure. This school of thought is generally viewed as a purely theoretical result, since it assumes a perfect market and disregards factors such as fluctuations and uncertain situations that may arise in financing a firm. In academia, much attention has been given to debating and relaxing
966-463: The appropriate mix of short-term debt and long-term debt. Increasing the percentage of short-term debt can enhance a firm's financial flexibility, since the borrower's commitment to pay interest is for a shorter period of time. But short-term debt also exposes the firm to greater refinancing risk . Therefore, as the percentage of short-term debt in a firm's capital structure increases, equity holders will expect greater returns on equity to compensate for
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#17328439720741012-413: The assumptions made by Miller and Modigliani to explain why a firm's capital structure is relevant to its value in the real world. Up to a certain point, the use of debt (such as bonds or bank loans) in a company's capital structure is beneficial. When debt is a portion of a firm's capital structure, it permits the company to achieve greater earnings per share than would be possible by issuing equity. This
1058-401: The base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. Some other reasons include bankruptcy costs , agency costs , taxes , and information asymmetry . This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of
1104-409: The basis for modern academic thinking on capital structure. It is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure process factors like fluctuations and uncertain situations that may occur in the course of financing a firm. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides
1150-462: The business cycle and can result in the observed patterns. Others have related these patterns with asset pricing puzzles. Corporate leverage ratios are initially determined. Low relative to high leverage ratios are largely persistent despite time variation. Variation in capital structures is primarily determined by factors that remain stable for long periods of time. These stable factors are unobservable. Firms rationally invest and seek financing in
1196-423: The business enters a contraction phase. The interest on the debt must be paid regardless of the level of the company's operating income, or bankruptcy may be the result. If the firm does not prosper and profits do not meet management's expectations, too much debt (i.e., too much leverage) increases the risk that the firm may not be able to pay its creditors. At some point this makes investors apprehensive and increases
1242-449: The cost of capital as low as possible. Capital structure is an important issue in setting rates charged to customers by regulated utilities in the United States. The utility company has the right to choose any capital structure it deems appropriate, but regulators determine an appropriate capital structure and cost of capital for ratemaking purposes. Various leverage or gearing ratios are closely watched by financial analysts to assess
1288-403: The fiduciary. Capital structure In corporate finance , capital structure refers to the mix of various forms of external funds, known as capital , used to finance a business. It consists of shareholders' equity , debt (borrowed funds), and preferred stock , and is detailed in the company's balance sheet . The larger the debt component is in relation to the other sources of capital,
1334-437: The firm than investors) issue new equity, investors believe that managers think the firm is overvalued, and managers are taking advantage of the assumed over-valuation. As a result, investors may place a lower value to the new equity issuance. The capital structure substitution theory is based on the hypothesis that company management may manipulate capital structure such that earnings per share (EPS) are maximized. The model
1380-487: The firm's cost of borrowing or issuing new equity. It is important that a company's management recognizes the risk inherent in taking on debt, and maintains an optimal capital structure with an appropriate balance between debt and equity. An optimal capital structure is one that is consistent with minimizing the cost of debt and equity financing and maximizing the value of the firm. Internal policy decisions with respect to capital structure and debt ratios must be tempered by
1426-445: The firm. Consider a perfect capital market (no transaction or bankruptcy costs; perfect information ); firms and individuals can borrow at the same interest rate; no taxes ; and investment returns are not affected by financial uncertainty. Assuming perfections in the capital is a mirage and unattainable as suggested by Modigliani and Miller. Modigliani and Miller made two findings under these conditions. Their first 'proposition'
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1472-483: The greater financial leverage (or gearing, in the United Kingdom) the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital . Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds
1518-474: The hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary. tranche In structured finance , a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk . Transaction documentation (see indenture ) usually defines the tranches as different "classes" of notes, each identified by letter (e.g.,
1564-466: The increased risk, according to a 2022 article in The Journal of Finance . In the event of bankruptcy, the seniority of the capital structure comes into play. A typical company has the following seniority structure listed from most senior to least: In practice, the capital structure may be complex and include other sources of capital. Financial analysts use some form of leverage ratio to quantify
1610-407: The law of least effort, or of least resistance, preferring to raise equity as a financing means "of last resort". Hence, internal financing is used first; when that is depleted, debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt
1656-403: The lower rated tranches. For example, senior tranches may be rated AAA, AA or A, while a junior, unsecured tranche may be rated BB. However, ratings can fluctuate after the debt is issued, and even senior tranches could be rated below investment grade (less than BBB). The deal's indenture (its governing legal document) usually details the payment of the tranches in a section often referred to as
1702-473: The market average interest rate on corporate bonds after corporate taxes, which is a reformulation of the ' Fed model '. The second prediction has been that companies with a high valuation ratio, or low earnings yield, will have little or no debt, whereas companies with low valuation ratios will be more leveraged. When companies have a dynamic debt-equity target, this explains why some companies use dividends and others do not. A fourth prediction has been that there
1748-441: The models above as well as others into a structured theoretical setup that is time-consistent and that has a dynamic set up similar to one that can be observed in the real world. Managerial contracts, debt contracts, equity contracts, investment returns, all have long lived, multi-period implications. Therefore, it is hard to think through what the implications of the basic models above are for the real world if they are not embedded in
1794-408: The more junior tranches of structured products are often bought by specialist credit investors, while the senior tranches appear to be more attractive for a broader, less specialised investor community". Here is a simplified example to demonstrate the principle: For example: Tranching offers the following benefits: Tranching poses the following risks: The cardinal principle in the mortgage crisis
1840-416: The payment of the tranches in a section often referred to as the waterfall (because the monies flow down). Tranches with a first lien on the assets of the asset pool are referred to as senior tranches and are generally safer investments. Typical investors of these types of securities tend to be conduits , insurance companies , pension funds and other risk averse investors . Tranches with either
1886-625: The proportion of debt and equity in a company's capital structure, and to make comparisons between companies. Using figures from the balance sheet, the debt-to-capital ratio can be calculated as shown below. The debt-to-equity ratio and capital gearing ratio are widely used for the same purpose. Capital bearing risk includes debentures (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate). Capital not bearing risk includes equity. Therefore, one can also say, Capital gearing ratio = (Debentures + Preference share capital) : (shareholders' funds) Capital structure
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1932-478: The same security may be paid pari passu . The more senior rated tranches generally have higher bond credit ratings (ratings) than the lower rated tranches. For example, senior tranches may be rated AAA, AA or A, while a junior, unsecured tranche may be rated BB. However, ratings can fluctuate after the debt is issued, and even senior tranches could be rated below investment grade (less than BBB). The deal's indenture (its governing legal document) usually details
1978-421: The senior tranches appear to be more attractive for a broader, less specialised investor community". Here is a simplified example to demonstrate the principle: For example: Tranching offers the following benefits: Tranching poses the following risks: The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to
2024-407: The term's use in structured finance may be singled out as particularly important. Use of "tranche" as a verb is limited almost exclusively to this field. All the tranches together make up what is referred to as the deal's capital structure or liability structure. They are generally paid sequentially from the most senior to most subordinate (and generally unsecured), although certain tranches with
2070-401: Was extended to include the effect of taxes and risky debt. Under a classical tax system , the tax-deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure would be to have virtually no equity at all, i.e. a capital structure consisting of 99.99% debt. If capital structure
2116-426: Was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk . That is, as leverage increases, risk is shifted between different investor classes, while the total firm risk is constant, and hence no extra value created. Their analysis
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