How Does the CMO Structure Work
A typical collateral group is structured into 10-20 different classes or tranches. Each class can have a different coupon, expected average life (the weighted average time the principal is outstanding) and cash flow schedule. This unique structure enables the issuer to transform a pool of 30-year mortgage pass-through securities into a series of bonds each designed to meet the need of a different investor group.
The issuer predetermines the order in which the classes will be retired. Each month as the cash flow from the underlying collateral is received, the trustee will disburse the interest and principal to the classes based on a predetermined set of rules. Thereby, principal and interest will be directed to some classes while others will receive interest only for some period. After the shortest maturity class has been fully retired, the principal will then be directed to the next class in line. This type of structure allows investors in the longer-term classes to enjoy steady interest income for several years as the early classes absorb the principal prepayments.
It is important to note that the yield and average life of each class will fluctuate depending on changes in current interest rates. When considering the benefits of investing in CMOs, potential investors should equally consider the risks of CMO investing, including but not limited to, credit, interest rate and pre-payment risks.
The following illustrations depict the most basic CMO structure - the sequential pay. However, most issues have more classes with different cash-flow allocations.
Please consult your financial advisor prior to investing any money in these or other products. These products are offered through many but not all broker-dealers. This information does not constitute an offer to sell or a solicitation of an offer to buy the securities, nor shall there be any sale of those securities, in any state or jurisdiction in which such an offer, solicitation or sale would be unlawful. Certain products are offered by prospectus or offering circular only. Product suitability must be determined for each individual investor.
CMOs are complex securities and are not suitable for all investors. The average life and yield of a CMO will fluctuate depending on the actual prepayment experience of the underlying mortgages and changes in current interest rates. If CMOs are sold in the secondary market prior to maturity, the proceeds received may be more or less than the original amount invested. When considering the benefits of investing in CMOs, potential investors should equally consider the risks of CMO investing, including but not limited to, credit, interest rate, extension and pre-payment risks.