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Definition: Active Tranche
This term is generally used in reference to the structuring of Mortgage Backed Securities (MBS) such as Collateralized Mortgage Obligations (CMO’s). Tranche is a French word that stands for “slice” or “portion”. The CMO structure allows the issue to be broken down into parts called as “tranches” and interest is paid to all the investors but principal is adjusted and paid out according to a set schedule in the CMO prospectus.
This arrangement helps the issuer to meet the varied maturity requirements of the investors and sell to them. An active tranche refers to the tranche of a CMO that is currently receiving the principal payments in addition to the interest. Once the active tranche receives the final payment, it is said to be “retired” and the next tranche in the CMO schedule is said to become “active”.
As investors have varied requirements, some of them would like to receive the proceeds in the short time let us say within 2 years while others want to receive it after 2 years i.e., they have a long term requirement for funds. The tranches of a CMO is designed accordingly so that one class of investors receive the earlier cash flows and the other receive later ones. Thus a seemingly unattractive security issue now becomes very attractive to a wide range of investors. Hence in the first 2 years of time, active tranche refers to the tranche that is paying interest along with principal to the first class of investors whereas in the next 2 years, active tranche refers to the other set of investors.
This type of flexibility of CMOs has led to quite complex and varied structures and it is possible to even have 50 or more tranches in a single issue.