Time Tranching

Question

I understand the concept behind credit tranching with the structure and having lower credit absorbing the losses first before B holders, and then A.However, does someone have an example with time tranching? Lets say a customer defaults and losses are $10M Bond Holder A: $2M par valueBond Holder B: $6M par valueBond Holder C: $4M par valueNow would you take A first, then B, then C for TIME TRANCHING? For Credit, you would take C first, then B, (A would not absorb any losses as C and B take it all).

Analyst0719 · Answer

Time tranching has more to do with setting up tranches to suit different investors with different maturity preferences. Investors who preferred to hold bonds with shorter maturities will invest in tranches that accept a lot of mortgage prepayments. So if the underlying mortgage get paid off faster, than the tranche will have shorter lives. Investors who prefer to hold bonds with longer maturities will invest in tranches that accept fewer mortgage prepayments. So these tranches will have longer maturities. Does that make sense?

hairyfairy · Answer

Credit tranches are relating to default situations (addressing credit risk), whereas time tranches are for cash flow and payments (prepayment risk). So time-tranching (or prepayment tranching) determines how principal cashflows are allocated. This can be sequential (senior tranche first) or some other custom parameters, depending on why/how the product was structured.