How do PAC tranches in a CMO protect against prepayment risk, and what happens to the companion tranche?
CFA Level II fixed income securitization. I understand that a CMO redistributes MBS cash flows into tranches with different risk profiles. But the PAC (Planned Amortization Class) tranche confuses me -- how exactly does it achieve predictable cash flows, and what is the 'companion' or 'support' tranche absorbing?
CMO PAC tranches are one of the most elegant structures in fixed income, and they're a staple of CFA Level II. The key insight is that PACs achieve stability by transferring prepayment risk to another tranche -- the companion.
How a PAC Tranche Works
A PAC tranche is designed to receive a fixed, predictable schedule of principal payments as long as prepayments stay within a specified range called the PAC collar (also called the PAC band).
For example, a PAC might have a collar of 100 PSA to 300 PSA. As long as actual prepayments fall within this range, the PAC tranche receives exactly its scheduled cash flows -- no more, no less.
The Companion Tranche Absorbs the Variability
The companion (support) tranche acts as a buffer:
- When prepayments are fast (say 250 PSA): More principal flows in than the PAC needs. The excess goes to the companion tranche, which receives principal faster than expected.
- When prepayments are slow (say 125 PSA): Less principal flows in. The PAC still gets its scheduled amount, and the companion receives less (possibly nothing until the PAC schedule is fulfilled).
- When prepayments break the collar (below 100 or above 300 PSA): Even the PAC schedule can't be maintained, and the PAC tranche itself faces prepayment risk.
Numerical Illustration: Ashford Mortgage Trust CMO (fictional)
Consider a $500 million mortgage pool creating:
- PAC tranche: $350 million (collar: 100-250 PSA)
- Companion tranche: $150 million
| Scenario | Actual PSA | PAC Gets | Companion Gets | Companion WAL |
|---|---|---|---|---|
| Slow prepay | 80 PSA | Less than scheduled (broken collar) | Almost nothing | Very long |
| Low end of collar | 100 PSA | Exactly scheduled | Minimal, stretched | 15 years |
| Mid-range | 175 PSA | Exactly scheduled | Moderate flow | 8 years |
| High end of collar | 250 PSA | Exactly scheduled | Accelerated | 3 years |
| Fast prepay | 350 PSA | More than scheduled (broken collar) | Fully paid down fast | <2 years |
The companion tranche's weighted average life (WAL) can swing from 2 years to 15+ years depending on prepayments. This extreme variability is the price for giving the PAC its stability.
Why PAC Tranches Have Lower Yields
Since PAC holders face less prepayment uncertainty (within the collar), they accept a lower yield. Companion tranche investors demand a higher yield to compensate for absorbing all the variability.
Effective Collar Narrowing
As the companion tranche gets paid down (either through fast or slow prepayments), its ability to buffer shrinks. This means the PAC's effective collar narrows over time -- it becomes more vulnerable to prepayment risk as the companion erodes.
Exam Tip: CFA questions love asking what happens to each tranche under different PSA scenarios. Remember: within the collar, PAC is rock-solid; outside the collar, both tranches face risk. Also know that PAC I has priority over PAC II if there are multiple PAC classes.
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