CFA Level II ExamFixed IncomeMedium
A portfolio manager is constructing a portfolio of mortgage-backed securities (MBS) and is concerned about the timing of principal repayments. The manager wants to minimize the risk that borrowers pay off their mortgages faster than expected, especially when interest rates decline. Which of the following MBS tranches is best suited for this objective?
- ATargeted Amortization Class (TAC) Tranche
- BCompanion Tranche
- CSupport Tranche
- DPlanned Amortization Class (PAC) Tranche
Show answer & explanationAnswer & explanation
Correct answer: D. Planned Amortization Class (PAC) Tranche
A Planned Amortization Class (PAC) tranche is designed to have a more predictable cash flow schedule and prepayment risk by absorbing a certain range of prepayment speeds. It achieves this by shifting prepayment risk to companion (or support) tranches. This makes PAC tranches the most suitable for minimizing prepayment risk within a specified range.
Why the other options are wrong
- A. TAC tranches provide protection against contraction risk (fast prepayments) but offer less protection against extension risk than PACs.
- B. Companion tranches are another name for support tranches and bear the brunt of prepayment risk.
- C. Support tranches absorb excess or deficient prepayments, making them highly susceptible to prepayment risk.
PAC Tranche Prepayment Protection
A Planned Amortization Class (PAC) tranche in a CMO is structured to provide a more stable and predictable stream of principal repayments.
- Achieves stability by absorbing prepayments within a 'collar' of speeds.
- Shifts prepayment risk to 'companion' or 'support' tranches.
- Offers protection against both contraction (fast prepayments) and extension (slow prepayments) risk.
Memory trick: PACs Provide Prepayment Predictability.