The cash flow from the CMO collateral may be allocated in a variety of ways. Usually, it is first allocated to meet the interest obligations on all tranches in the offering. Principal repayments, both scheduled and prepaid, are then distributed to the different classes of bondholders according to a predetermined priority schedule which is outlined in the prospectus or offering circular. The trance receiving principal repayment is referred to as active or currently paying. In more complex structures, more than one tranche can be paying principal at a time.
Each CMO tranche has an estimated first payment date, on which investors can expect to begin receiving principal payments, and an estimated last principal payment (or maturity) date, on which they can expect their final dollar of principal to be returned. The period before principal payments begin in the tranche, when investors receive interest-only payments, is known as the lockout period. The period during which principal repayments are expected to occur is called the window. Both first and last principal payment dates are estimates based on prepayment assumptions and can vary according to actual prepayments made on the underlying mortgage loans.
THE VARIOUS TYPE OF CMOS
The most basic CMO structure has tranches that pay in a strict sequence. Each tranche receives regular interest payments, but the 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 23 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 in a deliberate and sometimes uneven manner. This flexibility has led increasingly varied and complex CMO structures. CMOs may have 50 or more tranches, each with unique characteristics than may be interdependent with other tranches in the offering. The types of CMO tranches include:
Planned Amortization Class (PAC) Tranches
PAC tranches use a mechanism similar to a sinking fund to establish a fixed principal payment schedule that directs cash flow irregularities caused by faster or slower-than-expected prepayments away from the PAC tranche and toward another companion or support tranche. With a PAC tranche, the yield, average life and lockout 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 derived to no-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 tranche. When prepayments are minimal, the PAC payments are met first and the companion may have to wait. When prepayments are heavy, the PAC 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 - say, from 100 PSA. Type II and Type III PAC tranches can also be created with lower priority for principal payments from the underlying loans 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 now the most common type of CMO tranche, constituting over 50% of the new-issue market. Because they offer a high degree of investor cash-flow certainty, PAC tranches are usually offered at lower yields.
Targeted Amortization Class (TAC)
TAC tranches also provide more cash-flow certainty and a fixed principal payment schedule, based on a mechanism similar to a sinking fund, but this certainty applies at 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. The yields on TAC bonds are typically higher than yields on PAC tranches but lower than yields on companion tranches.
Companion Tranches (CT)
Every CMO that has a PAC or TAC tranches in it will also have companion tranches (also referred to as support bonds), which absorb the prepayment variability that is 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 interest 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 companion tranches further down in the principal payment priority. Companion tranche 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 (also known as Accretion Bonds or Accrual Bonds)
Z-tranches are structured so that they pay no interest until the lockout period ends and they begin to pay principal. 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 18-22 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 retirement accounts.
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), subject to an "upper limit, or cap," and sometimes to a lower limit, referred to as a "floor". The performance of these investments also depends on the way interest rate movements affect prepayment rates and average lives.
For the above reasons described, CMOs are considered by a select few platforms to be an asset that is easy to validate and prove ownership. In addition, the trading platform is able to be added as the CMOs Beneficiary allowing for the appropriate financing to be obtained. The result is a CMO asset that can be purchased for pennies on the dollar with nominal returns and subsequently placed and traded successfully in a Private Trading Program with yields the owner once only dreamed of.
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