Credit and Default Risk
When evaluating credit and default risks, investors should consider the characteristics of the underlying mortgage pool carefully, including the terms of the pooled mortgages, the underwriting standards, whether the CMO is backed by a Government agency, etc.
Cash Flow
CMOs are available in a variety of average lives and with varying sensitivity to changes in prepayment speeds, allowing investors to choose the class that best meets their investment objectives. They deliver monthly cash flow of either interest only and ultimately principal, or interest and principal until the bond is retired. Accrual bonds are an exception. Accrual bonds offer monthly compounding of interest until a conversion date, at which time monthly cash flow is paid to the investor.
Minimum Investments, Transaction Costs & Liquidity
Most CMO tranches sold to individual investors are available in $1,000 denominations. Mortgage securities dealers execute CMO transactions over-the-counter. Transactions are done at a net cost which includes the dealer spread or profit on the trade. Spreads on CMOs are generally wider than on Treasuries or Agency debentures, because the Treasury market is generally broader and more liquid.
Although there is an active secondary market for CMOs, the degree of liquidity can vary widely. The unique characteristics of individual CMO tranches place limitations on the potential liquidity of the product. Accordingly, if these investments are sold in the secondary market prior to maturity or a call date, they may be worth less than their original cost.
CMO Settlement Dates and Payment Dates
Investors who purchase CMOs at issuance – the “issue date” – may find that their transaction takes up to a month to “settle” because of the time required to assemble the collateral, deposit it with the trustee, and complete other legal and reporting requirements. In the secondary market, CMO transactions typically settle in three business days.
Because payments to CMO investors depend on the collection and distribution of payments made by the holders of the underlying mortgage loans, a payment delay occurs when the security is first purchased. “Payment dates” for CMO tranches are defined in the prospectus and are usually stated as the 15 th or 25 th day of the month following the record date. Depending on when the CMO transaction settles, the investor may have to wait up to two months for the first payment, but this delay is factored into the yield quoted at the time of purchase. Once the first payment is received, future payments will be made monthly.
Tax Considerations
Investors should be aware that interest income on CMOs is subject to federal, state and local income tax, while Treasury securities are exempt from state and local income tax.
CMO payments that represent the return of principal are not taxable. However, similar to corporate bonds and other taxable fixed-income investments, CMOs purchased at a discount to par may be subject to Original Issue Discount (OID) tax. Investors should have a comprehensive understanding of all tax related matters associated with CMO investing and should contact their tax advisor, if applicable, prior to any CMO (or other security) investment.
Coupon Features
CMOs with higher coupons typically have shorter average lives while issues with lower coupons typically have longer lives. Please see the respective offering documents for additional considerations.
Interest Rate Risk
Bond prices in the secondary market typically rise when interest rates fall, and because of the risk or prepayment or extension discussed below the secondary market price of a CMO may rise may rise or decline less than a typical fixed-income instrument. Hence, there may be a greater interest rate risk associated with a CMO/MBS than other fixed-income products.
Prepayment Risk
Prepayment risk is the risk that the homeowner will pay off more than their required monthly mortgage payments and is usually precipitated by a decline in interest/borrowing rates. This is may occur in an environment with decreasing interest rates.
Extension Risk
Extension risk is the risk that the homeowner will decide not to make their mortgage payments as initially expected and will instead make only minimum payments; and thus, not paying down the mortgage as quickly as initially expected. This is may occur in an environment with increasing interest rates.
Please see the respective offering documents for additional features and risk considerations respective to the specific investment.