How do CMO sequential-pay tranches redistribute prepayment risk?

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AcadiFi · Accepted Answer

A sequential-pay CMO carves a single pool's cash flow into time-ordered tranches so that different investors get different maturity profiles from identical collateral. In Avondale CMO 2026-3, $800M of pool collateral funds four classes: - Class A: $240M, WAL ~2.4 years - Class B: $200M, WAL ~5.1 years - Class C: $220M, WAL ~8.7 years - Class Z (accrual): $140M, WAL ~18.2 years Rule: all tranches receive interest on their outstanding balance each month, but principal (scheduled + prepaid) goes 100% to Class A until it is retired, then 100% to B, then C. Class Z accrues interest (no coupon paid) and begins receiving principal only after A, B, and C are gone. ```mermaid flowchart LR P[Pool principal
cash flow] --> A[Class A] A -->|when A retired| B[Class B] B -->|when B retired| C[Class C] C -->|when C retired| Z[Class Z accrual] ``` Consequence: Class A absorbs nearly all early prepayments, so it has stable short duration. Class C has long duration but insulated from early prepays. Z acts like a zero-coupon equivalent. Investors pick the slot matching their liability profile — insurers love Cs and Zs, money market funds love shorter As. Sequentials don't eliminate prepay risk; they concentrate it by maturity bucket.

How do CMO sequential-pay tranches redistribute prepayment risk?

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