What does tranching refer to in the context of collateral-backed securities?

Tranching in the context of collateral-backed securities refers to the process of creating different risk classes, or "tranches," that represent varying levels of risk and return. This method allows the structuring of securities to appeal to a range of investors with different risk appetites. Each tranche has its own credit rating, coupon payments, and priority in the event of default.

By segmenting the securities into tranches, issuers can attract conservative investors looking for safer, lower-yielding investments, as well as those who seek higher returns and are willing to accept more risk. This system enhances marketability, potentially resulting in lower overall borrowing costs for the issuer since it can cater to diverse investor preferences.

The other options do not capture the essence of tranching. Selling bonds at a discount is a different financial practice that does not pertain to risk classification. The allocation of dividends among shareholders relates to equity rather than debt securities, and a tax incentive for investors is a financial tool not directly associated with the structure of tranches in collateral-backed securities.