With mortgage pass-through securities, investors share equally in interest coupon and principal cash flows and therefore all assume equal prepayment, extension, and contraction risk.
CMO structures will take one or more pass-through securities, divide up the cash flows, and then prioritize the cash flows from the collateral to different bond classes called tranches. These tranches will have different risk and return profile. So, there will be several classes of bondholders with varying maturities or different date of maturities, known as tranches.
The tranches do not change the overall prepayment risk of the underlying assets; the tranches simply reallocate that risk among the CMO’s investors.
Sequential Pay Tranches
Each tranche receives its pro-rata share of interest payments, but principal prepayments will first be allocated to Tranche A bonds until those bonds are retired, then to Tranche B bonds, etc.
Tranche A will be protected against extension risk, but the other bonds will be protected from contraction risk until Tranche A principal is retired.
Accrual Bonds or Z-tranche
Accrual bonds or Z-tranches do not receive cash payments from interest on the underlying collateral, rather interest is accrued to the accrual bonds’ principal value and then paid once the other tranches are paid off.
Accrual bonds allow investors to avoid reinvestment risk since no coupon interest is paid until all sequential bonds have been retired.
Planned Amortization Class (PAC) Tranche
These bonds will help an investor manage prepayment risk. Commonly the PAC is split into two tranches: a PAC tranche and a Support tranche (or companion tranche).
The PAC tranche will have a band or collar that sets controls on the principal payments allocated to it.
The initial PAC collar will have a minimum and maximum PSA speed.
Prepayment fluctuations outside the PAC collar band are then absorbed by the Support tranche. Therefore the support tranche absorbs most of the prepayment risk.