About MBS/ABS
Types of CMOs
Sequential Pay
The most basic CMO structure is made up of tranches that pay in a strict sequence. Each tranche receives regular interest payments, but principal payments received are made to the first tranche alone until it is completely retired. Once the first tranche is retired, principal payments are applied to the second tranche until it is fully retired, and the process continues until the last tranche is retired.The first tranche of the offering may have an average life of 2-3 years, the second tranche 5-7 years, the third tranche 10-12 years, and so forth. This type of CMO is known as a sequential pay, clean or plain vanilla offering. The CMO structure allows the issuer to meet different maturity requirements and to distribute the impact of prepayment variability among tranches. This flexibility has led to increasingly varied and complex CMO structures. CMOs may have multiple tranches, each with unique characteristics that may be interdependent with other tranches in the offering. The types of CMO tranches include:
Planned Amortization Class (PAC) Tranches. Planned Amortization Class (PAC) tranches use a mechanism similar to a sinking fund to establish a fixed principal payment schedule that directs cashflow irregularities caused by faster- or slower-than expected prepayments away from the PAC tranche and toward another tranche. With a PAC tranche, the yield, average life, and lockout periods estimated at the time of investment are more likely to remain stable over the life of the security.
PAC payment schedules are protected by priorities which assure that PAC payments are met first out of principal payments from the underlying mortgage loans. Principal payments in excess of the scheduled payments are diverted to non-PAC tranches in the CMO structure called companion or support tranches because they support the PAC schedules. In other words, at least two bond tranches are active at the same time, a PAC and a companion or support tranche. When prepayments are minimal, payments are made first to the PAC tranche while the companion tranche may have to wait to refeive payments. When prepayments are heavy, the PAC tranche pays only the scheduled amount, and the companion class absorbs the excess.
Type I PAC tranches maintain their schedules over the widest range of actual prepayment speeds, for example from 100% to 300% PSA. Type II and Type III PAC tranches can be created with lower priority for principal payments from the underlying collateral than the primary or Type I tranches. They function as support tranches to higher-priority PAC tranches and maintain their schedules under increasingly narrower ranges of prepayments.
PAC tranches are a common type of CMO tranche. Because they offer a higher degree of cash-flow certainty, PAC tranches are usually offered at lower yields.
Targeted Amortization Class (TAC) Tranches. Like PAC tranches, Targeted Amortization Class (TAC) tranches also provide more cash-flow certainty and a fixed principal payment schedule. However, this certainty applies to only one prepayment rate rather than a range. If prepayments are higher or lower than the defined rate, TAC bondholders may receive more or less principal than the scheduled payment. TAC tranches’ actual performance depends on their priority in the CMO structure and whether or not PAC tranches are also present. If PACs are also present, the TAC tranche will have less cash-flow certainty. If no PACs are present, the TAC provides the investor with some protection against accelerated prepayment speeds and early return of principal. Yields on TAC bonds are typically higher than yields on PAC tranches, but lower than yields on companion tranches.
Companion Tranches. As mentioned, every CMO that has PAC or TAC tranches will also have companion or support tranches to absorb the prepayment variability that has been removed from the PAC and TAC tranches. Once the principal is paid to the active PAC and TAC tranches according to the schedule, the remaining excess or shortfall is reflected in payments to the active companion tranche. The average life of a companion tranche may vary widely, increasing when interest rates rise and decreasing when rates fall. To compensate for this variability, companion tranches offer the potential for higher expected yields when prepayments remain close to the rate assumed at purchase. Similar to Type II and Type III PACs, TAC tranches can serve as companion tranches for PAC tranches. These lower-priority PAC and TAC tranches will in turn have companion tranches further down in the principal payment priority. Companion tranches are often offered for sale to retail investors who want higher income and are willing to take more risk of having their principal returned sooner or later than expected.
Z-Tranches. Z-tranches, also known as accretion bonds or accrual bonds, are structured so that they pay no interest until the lockout period ends and principal payments begin. Instead, a Z-tranche is credited “accrued interest” and the face amount of the bond is increased at the stated coupon rate on each payment date. During the accrual period the principal amount outstanding increases at a compounded rate and the investor does not face the risk of reinvesting at lower rates if market yields decline. Typical Z-tranches are structured as the last tranche in a series of sequential or PAC and companion tranches and have average lives of 18 to 22 years. However, Z-tranches can be structured with intermediate-term average lives as well. After the earlier bonds in the series have been retired, the Z-tranche holders start receiving cash payments that include both principal and interest.
While the presence of a Z-tranche can stabilize the cash flow in other tranches, the market value of Z-tranches can fluctuate widely, and their average lives depend on other aspects of the offering. Because the interest on these securities is taxable when it is credited, even though the investor receives no interest payment, Z-tranches are often suggested as investments for tax-deferred accounts.
Principal-Only (PO) Securities. Some mortgage securities are created so that investors receive only principal payments generated by the underlying collateral; the process of separating the interest payments from the principal payments is called stripping. These Principal-Only (PO) securities may be created directly from mortgage pass-through securities, or they may be tranches in a CMO. In purchasing a PO, investors pay a price deeply discounted from the face value and ultimately receive the entire face value through scheduled payments and prepayments.
The market values of POs are extremely sensitive to prepayment rates. If prepayments accelerate, the value of the PO will increase. On the other hand, if prepayments decelerate, the value of the PO will drop. A companion tranche structured as a PO is called a Super PO.
Interest-Only (IO) Securities. When creating a PO mortgage security, the resulting stripped interest payments necessitate the creation of Interest-Only (IO) securities. IO securities are sold at a deep discount to their notional principal amount, namely the principal balance used to calculate the amount of interest due. They have no face or par value. As the notional principal amortizes and prepays, the IO cashflow declines.
Unlike POs, IOs increase in value when interest rates rise and prepayment rates slow; consequently, they are often used to hedge portfolios against interest rate risk. However, IO investors take on the risk that if prepayment rates are high enough, they may actually receive less cash back than they initially invested.
The structure of IOs and POs exaggerates the effect of prepayments on cash flows and market value. The heightened risk associated with these securities makes them unsuitable for certain investors.
Floating-Rate Tranches. First offered in 1986, floating-rate CMO tranches carry interest rates that are tied in a fixed relationship to an interest rate index, such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI). These tranches are subject to an upper and sometimes a lower limit, the cap and floor respectively. The performance of these investments depends largely on the way interest rate movements affect prepayment rates and average lives.
Sometimes the interest rates on these tranches are stated in terms of a formula based on the designated index, meaning they move up or down by more than one basis point for each increase or decrease in the index. These so-called super-floaters offer leverage when rates rise. The interest rates on inverse floaters move in a direction opposite to the changes in the designated index and offer leverage to investors who believe rates may move down. The potential for high coupon income in a rally can be rapidly eroded when prepayments speed up in response to falling interest rates. All types of floating-rate tranches may be structured as PAC, TAC, companion, or sequential tranches, and are often used to hedge interest rate risks in portfolios.
Residuals. CMOs also contain a residual interest tranche, which collects any cash flow remaining from the collateral after the obligations to the other tranches have been met. Residuals are not classified as regular interest and may be structured as sequential, PAC, floating-rate, or inverse-floater tranches, and differ from regular tranches primarily in their tax characteristics, which can be more complex than other CMO tranches. CMOs issued as non-REMICs also have residuals which are sold as a separate security such as a trust certificate or a partnership interest.
Callable Pass-Throughs. Callable pass-throughs can be used as collateral to back CMOs. Investors should be aware that a call of some or all of the underlying callable pass-throughs may result in a call of all of the outstanding tranches in the CMO they invested in. This can be particularly important to holders of long-term classes.
All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.