As a loan officer, you will come across tranches when a borrower comes to you for help moving the risk of CMO prepayment penalties. However before you do, you need to know how they work and how they can affect you and your borrower.
PACs are More Predictable
Planned amortization class tranches (PACs) are a type of schedule bond tranche that have a payment schedule. In this schedule, cash flows are prioritized with PAC payments first, then the companion tranches. Investors get fixed principal payments during the PAC window, but only if the mortgage prepayment isn’t too fast or too slow.
If the prepayment is slow, then the tranche will get more money from principal payments to prevent a life expansion. On the other hand, if prepayment is too fast, the companion tranche gets any excess and its life is expanded to protect the PAC. This scheduling ensures that cash flows are more predictable than other tranches.
PACs Have Companion Tranches
Companion tranches can be found in PACs and offer support for any overflow of funds, which protects the PAC by preventing the life of the PAC from getting longer. The reason this prevention is so important is because if the life of the PAC is expanded, then the bond will take longer to meet its maturity date.
The 3 Types of PACs
PACs have three different types. Type I maintain their schedules regardless of prepayment speeds, and Type II and III offer support to PAC tranches that are of a higher priority. Like Type I, they maintain their schedules.
Research before Investing
Before you invest in a PAC tranche, it’s important that you research your options beforehand. That way, you know what you’re getting into and won’t be surprised by any potential risks.