The Various Types of CMOs

he 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 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 in a deliberate and sometimes uneven manner. This flexibility has led to increasingly varied and complex CMO structures. CMOs may have 50 or more tranches, each with unique characteristics that may be interdependent with other tranches in the offering. The types of CMO tranches include:

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 (see below). 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 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% to 300% 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. Because they offer a high degree of investor cash-flow certainty, PAC tranches are usually offered at lower yields.

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.

Every CMO that has PAC or TAC tranches in it will also have companion tranches (sometimes called 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 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 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 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 retirement accounts. (See also “Jump Z-tranche” in the Glossary.)

Some mortgage securities are created so that investors receive only principal payments generated by the underlying collateral. 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 security, 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 and therefore interest rates. If interest rates are falling and prepayments accelerate, the value of the PO will increase. On the other hand, if rates rise and prepayments slow, the value of the PO will drop. A companion tranche structured as a PO is called a “Super PO.”

Separating principal payments to create PO mortgage securities necessarily involves the creation of Interest-Only (IO) securities. CMOs that have PO tranches will therefore also have IO tranches. 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 cash flow 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. IO investors should be mindful that if prepayment rates are high, 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.

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, or “floor.” The performance of these investments also depends 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” (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.

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.