If you have collateralized mortgage obligations, you know that they could be at risk of prepayment penalties if they mature too early. Thankfully, there are ways you can help move the risk to avoid these penalties.
Why Move the Risk of Prepayment Penalties?
Prepayment penalties happen because when a borrower pays off a loan early, they save money in interest but the lender misses out on that interest. CMOs, a type of mortgage-backed security, are attractive investments because they tend to yield higher returns than government bonds, but at a risk. Moving the risk of prepayment penalties means that investors
Distribute CMOs Between Tranches
You can move the risk of prepayment penalties by distributing the CMOs into different tranches, to different effect. There are many different types of tranches that you can use to distribute CMOs between including, but not limited to:
- Sequential tranches
- Schedule bond tranches
- Targeted Amortization Class tranches
- Companion tranches
The two most popular tranches to do this with are sequential and schedule. While these are the more common ones, it’s advised that you talk to a financial advisor to find out which tranche is best for your CMO.
Sequential tranches has several tranches that each take in interest payments as long as the principal has not been paid off. Sequential tranches are the most basic tranche in that they are paid off from the tranche with the shortest maturity time to the highest. This structure means that the one with the shortest maturity timeline receives the principal payment before it expires and payment is moved to the next tranche in the timeline. The yield-to-maturity differs upon whether or not a tranche is paid off faster or slower than expected.
Schedule Bond Tranches
Schedule bond tranches, or planned amortization class tranches (PAC), put cash into companion tranches that come faster or slower than expected. This tranche has a predictable prepayment date and since the risk of prepayment risk is lower, it usually generates low yields. These yields, however, are stable throughout the life of the security.