Economic Value in Tranching of Syndicated Loans

This paper presents a theory to explain the economic value in tranching of syndicated loans. Over 35% of syndicated loans originated in the nineties had multiple tranches. These tranches were either for different types of loans (example, revolving and term loans) or had different terms and conditions (example, maturity, credit spread, and covenants). We present a model to explain this phenomenon. The model suggests that firms facing higher credit spreads have incentives to break their loans into two or more parts with different risk characteristics such that each part is attractive to a specific type of lender with defined level of risk aversion. This division of loan potentially decreases the overall cost for the borrowing firm. Empirically, we show that riskier firms are more likely to take loans with multiple tranches. Accordingly, the average credit spread on syndicated loans with multiple tranches exceeds that on non-tranched syndicated loans. However, after accounting for the risk characteristics of tranched loans, borrowings that are a part of tranched loans have lower credit spreads than otherwise identical non-tranched loans. Our results suggest that borrowing firms for an average syndicated loan with average maturity saved $1.5 million over the life of the loan during our sample period simply by tranching the loan into two or more parts. Our model predicts and we demonstrate that the benefits of tranching accrued primarily to risky borrowers and that these benefits were economically significant