Other CMO Structures
Tranches in mortgage-backed securities come in several flavors, and each has unique features, advantages, and risks.
| Tranche Name | Par Value $US | Coupon Rate |
|-------------------|-----------------|-------------|
| PAC tranche | $300,000,000 | 4% |
| Companion tranche | $200,000,000 | 4% |
What would you expect if PAC requires $150,000 ($50,000 this month in principal repayment and $100,000 in interest) and only a $45,000 prepayment is received?
Incorrect.
Payment rules must be followed exactly. There is no excess principal.
Incorrect.
Payment rules are provided and must be followed exactly. The support tranche assumes the principal variations.
Correct.
Although the payment is less than PAC tranche's monthly requirement, the PAC tranche gets all of it and the support tranche gets nothing this month. Interest payment was not specified, so all of the funds are applied toward principal repayment.
PAC tranches are usually seen with lower yields in the marketplace and prepayment risk is reduced.
Start with __Z-tranches__. They're a unique case where no interest payments are made until a preset date. Then, both principal and accrued interest payments kick in. How might other tranches benefit when a Z-tranche is part of the structure?
To summarize:
[[summary]]
Right!
Z-tranches hold back their cash flow until later, allowing other tranches to distribute more.
Not quite.
It's not about the interest rate distribution.
No, that's not correct. The principal doesn't decrease because of Z-tranches.
__Principal only (PO)__ securities pay only the principal, while __interest only (IO)__ securities pay only the interest from the mortgage pool. These can be used strategically to meet specific investment goals. Which of these would you expect to be more sensitive to prepayment rates?
Somewhat but not as much as PO securities. PO securities are highly sensitive to prepayment rates.
Correct! PO securities are highly sensitive to prepayment rates.
__Floating-rate tranches__ carry variable interest rates tied to an index or market reference rate, often subject to both a cap and a floor. They are a popular choice for hedging against interest rate risk. How do you think floating-rate tranches are affected by interest rate movements?
No, floating-rate tranches are directly affected by interest rate movements.
This isn't always the case. The interest rates on these tranches are variable, so their value can fluctuate.
Yes!
Interest rate changes influence prepayment rates, which directly affect the cash flows to floating-rate tranches.
Residual tranches collect the remaining cash flow after all obligations to the other tranches are met. Who would these tranches be most suitable for?
Incorrect.
Residual tranches are not typically suitable for risk-averse investors due to their level of risk.
Yes, exactly!
Residual tranches can be risky but offer potentially high returns for those who can manage the risks.
Not quite.
Residual tranches are typically more risky and unpredictable.
Lastly, there are __planned amortization class__ (PAC) tranches. This structure requires scheduled principal repayments to be specified for greater cash flow stability. When a PAC tranche is established, it is typically provided with a __support tranche__. This support tranche absorbs the prepayment excess above what is scheduled. Suppose the following tranches are provided:
PAC would receive $30,000, and the support tranche would receive $15,000
PAC would receive nothing, and the support tranche would receive $45,000
PAC would receive $45,000, and the support tranche would receive nothing
Continue
It reduces the total amount of principal to be repaid
It allows for better interest rate distribution
It frees up cash flows for other tranches
IO securities
PO securities
They are insensitive to interest rate movements
They increase in value whenever interest rates rise
They are impacted by how interest rate movements affect prepayment rates
Investors seeking a stable and predictable cash flow
Investors that can assume the risk
Risk-averse investors
