Series 7: CMO Structures

Taken from our Series 7 Top-off Online Guide  CMO Structures

CMOs are structured in a variety of ways to reapportion the risk among the tranches to appeal to different types of investors.

Sequential pay CMO. This is the most basic of CMO structures, also known as a plain vanilla offering. Each tranche in the CMO receives regular interest payments, but principal payments are made to only the first (the most senior) tranche until it is completely retired. After that, principal payments are applied to the next most senior tranche until it is fully retired, and so on until the last, most junior tranche is retired in sequence. The more senior-rated tranches generally have higher bond credit ratings than the lower rated tranches. Senior tranches are generally safer investments and appeal to more risk-averse investors. Junior tranches, sometimes referred to as “junior notes,” are more risky investments because they are not secured by specific assets and will appeal to only investors seeking higher risk/return profiles.

Planned amortization class (PAC). PAC tranches are 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 than other types of tranches. PAC payment schedules are protected by priorities that ensure that principal payments from the underlying mortgage loans go to the PAC first. Principal payments in excess of the scheduled payments are diverted to non-PAC tranches in the CMO structure, called companion or support tranches.

An owner of a PAC tranche is guaranteed a fixed amortization payment as long as prepayments stay within a certain range, or collar. If the principal is paid back at a faster rate than expected, the funds go into the companion tranche to protect against prepayment risk. If interest rates rise and principal is paid back more slowly, money will be transferred from the companion tranche to protect the PAC investor from extension risk. With a PAC tranche, the yield,

Since you're reading about Series 7: CMO Structures, you might also be interested in:

Solomon Exam Prep Study Materials for the Series 7
Please Enable Javascript
to view this content!