Tranches are portions of mortgage-backed securities that are split when a bank and it turns into a collateralized mortgage obligation. Each tranche is based on its date of maturity, or when a homeowner is scheduled to pay off their mortgage, then by risk.
The risk of tranches is determined by the requirements and terms of the mortgage and the chances that the homeowner will default. Tranches also run the risk of having investors using them incorrectly, as they can be complex. Therefore, it’s recommended to not put too much trust into tranches if you are an inexperienced lender and investor.
The best practices for using tranches after buying a mortgage-backed security depends on the type of tranche involved. Tranches can often be combined with each other to give investors flexibility when determining how to invest their money into different types of CMOs.
Sequential tranches are often referred to as “vanilla” CMOs because of their simplicity. There is more than one tranche set up in sequential order that is made to retire in that order. As principal payments are made, it will pay off the bonds in the first tranche until it retires and payments are put into the next tranche in line. This sequence continues until all tranches have been retired.
Schedule Bond Tranches
There are two types of schedule bond tranches:
- Targeted amortization class (TACs): A type of scheduled bond tranche that is paid on a predetermined schedule using a single PSA, or a prepayment model. TACs differ from PACs in that it only applies to one prepayment rate, rather than multiple. If the rate of prepayments is higher or lower, those who hold the bond will receive more or less principal than what they would otherwise get.
- Planned amortization class (PACs): Designed to produce a stable cash flow, PACs redirect the risk of prepayment by including companion tranches. More than one tranche is active at the same time and when there is less prepayments made, the PAC takes priority. If prepayments are higher, the PAC gets the scheduled amount and the rest is put into the companion tranche.
Companion tranches are used in planned amortization class (PAC) CMOs. They are also known as a support tranche because it supports the main PAC and gives it more stable and predictable cash flows. It also protects the PAC by taking on any extra principal when prepayments are made on the mortgage, and “deferring the receipt of principal payments when prepayments decrease.”
Investors who buy Z-tranches will only receive interest and principal payments after all other tranches have been paid, which makes them the riskiest of the tranches. The reason being, investors won’t get paid for a long period of time and if the mortgage defaults, they will be stuck
On the other hand, Z-tranches do make senior tranches more secure because those tranches will get paid first. Z-tranches also have minimal investment risk because it will continue to collect interest throughout its life.