Last time, we looked at coupon interest on pass-through securities, financial instruments bought and sold by prime brokers, among others. Today we discuss two other types of mortgage-backed securities.
Collateralized Mortgage Obligations (CMOs)
Collateralized Mortgage Obligations represent repackaged pass-through mortgage-backed securities, but with the cash-flows directed in a prioritized order based on the structure of the bond. A CMO’s objective is to provide some protection against the prepayment risk associated with mortgage investments, above and beyond the protection offered by pass-throughs, while still offering credit quality and high yields. CMOs take the cash-flows from pass-throughs and segregate them into different bond classes known as tranches, to provide the investor some level of payment predictability. Each tranche holds mortgage-backed securities with similar maturity and cash flow patterns. Each tranche is different from the others within the CMO. For example, a CMO might have four tranches with mortgages that average two, five, seven and 20 years each.
When the mortgage payments come in, the CMO issuer will first pay the stated coupon interest rate to the bondholders in each tranche. Scheduled and unscheduled principal payments will go first to the investors in the first tranches. Once they are paid off, investors in later tranches will receive principal payments. The concept is to transfer the prepayment risk from one tranche to another. Some CMOs may have 50 or more interdependent tranches. There are two types of tranches:
- Planned Amortization Class (PAC) Tranche – PAC tranches use the sinking fund concept to help investors reduce prepayment risk and receive a more stable cash flow. A companion bond is established to absorb excess principal as mortgages are paid off early. Then, with income from two sources (the PAC and the companion bond) investors have a better chance of receiving payments over the original maturity schedule.
- Z-Tranche – Z-tranches are also known as accrual bonds or accretion bond tranches. During the accrual period, interest is not paid to investors. Instead, the principal increases at a compound rate. This eliminates investors’ risk of having to reinvest at lower yields if current market rates decline. After prior tranches are paid off, Z-tranche holders will receive coupon payments based on the bond’s higher principal balance. Plus, they’ll get any principal prepayments from the underlying mortgages. Because the interest credited during the accrual period is taxable – even though investors don’t actually receive it – Z-tranches may be better suited for tax-deferred accounts.
Stripped Mortgage Securities
Stripped Mortgage Securities (Strips) are CMOs that pay investors principal only or interest only.
- Principal Only (PO) – Investors pay a deeply-discounted price for the PO and receive principal payments from the underlying mortgages. The market value of a PO can fluctuate widely based on current interest rates. As interest rates drop, prepayments can increase, and the PO’s value might rise. On the other hand, when current rates go up and prepayments decline, the PO could drop in value.
- Interest Only (IO) – An IO pays interest that is based on the amount of outstanding principal. As the mortgages amortize and prepayments reduce the principal balance, the IO’s cash flow declines. The IO’s value fluctuates opposite a PO’s in that as current interest rates drop and prepayments increase, the income can go down. When current interest rates rise, investors are more likely to receive interest payments over a longer period of time, thereby increasing the IO’s market value.