CFA Level II ExamFixed IncomeMedium
An investor is considering purchasing a collateralized mortgage obligation (CMO) with a planned amortization class (PAC) tranche. What is the primary benefit of investing in a PAC tranche compared to a standard sequential pay tranche?
- AExposure to a wider range of interest rate movements, enhancing diversification.
- BProtection from both extension and contraction risk within a specified prepayment range.
- CGuaranteed principal payments regardless of the underlying mortgage prepayments.
- DHigher expected yield due to increased prepayment risk.
Show answer & explanationAnswer & explanation
Correct answer: B. Protection from both extension and contraction risk within a specified prepayment range.
PAC tranches are designed to provide a more predictable stream of principal payments over a wide range of prepayment speeds by redirecting prepayments from companion tranches. This predictability offers protection against both extension risk (prepayments slower than expected) and contraction risk (prepayments faster than expected) within their defined PAC collar.
Why the other options are wrong
- A. Incorrect. PAC tranches are designed to reduce, not enhance, exposure to a wide range of prepayment and interest rate movements, thereby providing more stable cash flows.
- C. Incorrect. While PAC tranches offer more predictable principal payments, they are not guaranteed regardless of prepayments. Their stability is only within a defined prepayment collar, and they still depend on the underlying mortgage performance.
- D. Incorrect. PAC tranches offer more predictable cash flows, which typically comes at the cost of a slightly lower yield compared to more volatile tranches, and they are designed to mitigate, not increase, prepayment risk within a range.
Planned Amortization Class (PAC) Tranche
A PAC tranche in a CMO is designed to have a stable and predictable principal payment schedule over a specified range of prepayment speeds, offering protection against both extension and contraction risk.
- Achieves stability by having 'companion' or 'support' tranches.
- Protects against both extension risk (slow prepayments) and contraction risk (fast prepayments) within its collar.
- Offers more predictable cash flows than sequential pay or support tranches.
- Stability comes at the expense of its companion tranches, which absorb the variability.
Memory trick: PAC 'Pads' payments, 'Avoiding' prepayment shocks.