What are CMBS Tranches?
When CMBS loans are pooled together and securitized into commercial mortgage-backed securities, they are split into multiple tranches based on risk and return. CMBS tranches can generally be split into two major categories, investment-grade CMBS and sub-investment-grade CMBS. Investment-grade CMBS tranches are rated AAA/Aaa through BBB-/Baa3, while sub-investment-grade securities are ranked BB+/Ba1 through B-/B3. Cub-investment grade CMBS are often referred to as the CMBS B-piece.
Investors in Higher-Rated Tranches Get Lower Returns, Face Lower Risks
In general, the investors in the highest-rated CMBS are offered the lowest interest rates, but they face the least risk, as they are paid off first in the case of mortgage default. Investors in lower-rated CMBS tranches, including B-piece CMBS, receive a higher return but do not get paid until the A-class CMBS investors are fully repaid.
Risk-Retention Rules Force CMBS Lenders to Hold a Portion of All CMBS Tranches on Their Balance Sheets
Due to CMBS risk-retention rules, instituted by the Dodd-Frank Act of 2010 and first enforced in 2016, CMBS lenders must hold onto at least 5% of the CMBS they issue, including part of the B-piece tranches. This helps to ensure that the CMBS lenders' interests are aligned with the interests of the investors and that they do not recklessly offer loans to commercial real estate investors who are unlikely to pay them back. Prior to these rules, CMBS lenders were allowed to transfer 100% of the risk of the CMBS loans to the investors, which likely was one of the major contributors to the CMBS crisis of 2008-2010.