Mortgage-Backed Securities

Sequential Pay Tranches (SEQ)

• Most basic class within a CMO structure.
• Also called Plain Vanilla or Clean Pay classes.
• Principal is retired sequentially; that is one class begins to receive principal payments from the underlying securities only after the principal on any previous class has completely paid off.
• While the first class principal is paying down, the other class holders still receive monthly interest payments at the coupon rate on their principal.
• If prepayments are faster than the prepayment speed assumed when the security is purchased (at pricing), the principal is retired earlier than expected, thereby shortening the average life of each class. Likewise, the opposite would be true.
• Average life represents the average amount of time that each principal dollar is expected to be outstanding.
• Changes in the average life of the class may affect the yield-to-maturity of the bond.

Planned Amortization Class (PAC)

• PACs are designed to produce more stable cash flow by redirecting prepayments from the underlying securities to other classes called Support or Companion classes.
• PAC investors are scheduled to receive fixed principal payments, known as the PAC schedule, over a predetermined period of time, referred to as the PAC window, through a range of prepayment scenarios, known as the PAC band. The schedule will be met only if the underlying mortgages prepay at a rate within the range assumed for the structuring of the PAC for the life of the security.
• If prepayments are slow, a PAC tranche receives a greater share of principal to prevent its average life from lengthening, while an accompanying Support tranche receives less (thereby extending its average life). Similarly, if prepayments are fast, the Support tranche receives the excess principal and experiences a shortening of average life in order to protect the PAC.
• PAC Bonds are protected only within predefined Prepayment Speed Assumptions (“PSA”) bands.
• There are limits on how much protection a Support tranche can provide to a PAC. At the slow extreme of prepayment experience, all principal can be directed to the PAC and at the fast extreme, all principal can be directed to the Support. Once a Support tranche is paid off (should that occur before the PAC), however, the PAC is subject to unprotected variation in average life, like a Sequential Pay tranche.
• PACs offer investors the benefit of greater average life protection at the expense of reduced yield. Many institutions require average life stability for business purposes, but still find the yield of PACs attractive relative to other high quality investment alternatives. An individual investor may also at times, desire this average life stability.

Support Classes (also known as Companions)

• Support or Companion tranches tend to experience greater average life variability than the underlying collateral.
• Because a Support tranche may receive as much as all incoming prepayment or as little as none (on a portion of collateral), depending on speed of prepayment, its average life can vary significantly.
• Support tranches typically offer higher yield in return for acceptance of average life variability.
• Because PAC tranches can be sold at less yield than Sequentials (due to their attractive average life stability), additional yield is generally available to offer on Support tranches for investors who favor higher yield over average life predictability. Typically, individual investors have fewer constraints on the term of investments than do institutions (since businesses frequently must match assets and liabilities). As a result, the majority of Support tranches are sold to individual investors.

Z Tranches (or Accrual Bonds)

• Z tranches pay no principal or interest for a specified time period, called the accrual period.
• During the accrual period, Z tranches accrue value in a way similar to “Zero Coupon” bonds, in that interest accumulates on a monthly compounded basis. Of course, with compound interest, interest is earned each month not only on the original principal investment, but on the interest accumulated to date as well.
• After the accrual period ends, the Z tranche begins to pay principal and interest monthly until such time as principal is paid off (similar to a Sequential or Support “payer” tranche).
• The primary attraction of Z bonds is generally higher yield. For investors who can forgo the income during the accrual period, the ultimate earnings are typically higher than for other CMO tranches.
• The IRS requires tax payment for Zero coupon investments on interest that is earned, even though it has not yet been received. This means that investors must have sources of cash available other than interest from the Z bond, to pay taxes on interest income earned during the accrual period. For this reason, Z bonds are especially popular in tax-deferred accounts.

Floating-Rate 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), subject to an upper limit, or “cap”, and sometimes to a lower limit, or “floor”.
• The performance of floating-rate tranches also depends on the way interest rate movements affect prepayment rates and average lives.
• Sometimes the interest rate 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” (1/100 of one percent) for each basis point increase or decrease in the index. These so called “superfloaters” 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.

MBS are complex securities and are not suitable for all investors. The average life and yield of a MBS will fluctuate depending on the actual prepayment experience of the underlying mortgages and changes in current interest rates. If MBS are sold in the secondary market prior to maturity, the proceeds received may be more or less than the original amount invested.