NASAA Series 66 Uniform Combined State Law ExaminationInvestment Vehicle CharacteristicsHard
A portfolio manager is considering a collateralized mortgage obligation (CMO) for a client seeking predictable income. The client is concerned about reinvestment risk if interest rates fall. Which CMO tranche structure would best mitigate this specific risk?
- AA Targeted Amortization Class (TAC) tranche.
- BA Planned Amortization Class (PAC) tranche.
- CA Z-tranche.
- DA Companion (Support) tranche.
Show answer & explanationAnswer & explanation
Correct answer: B. A Planned Amortization Class (PAC) tranche.
PAC tranches are designed to provide a more predictable cash flow stream and a more stable average life within a specified prepayment range. They achieve this by having companion tranches absorb excess prepayments or shortfalls, thereby mitigating both extension and contraction risk, including reinvestment risk associated with early prepayments when interest rates fall.
Why the other options are wrong
- A. TAC tranches offer some protection against prepayment risk, but their cash flows are less stable than PACs and they do not offer the same level of protection against reinvestment risk.
- C. Z-tranches are accrual tranches that receive no principal or interest payments until all preceding tranches are paid off, making them unsuitable for predictable income and highly sensitive to interest rate changes.
- D. Companion (Support) tranches absorb the prepayment risk (both extension and contraction) that PAC tranches shed, making them highly susceptible to reinvestment risk when rates fall and prepayments accelerate.
Planned Amortization Class (PAC) Tranche
A type of Collateralized Mortgage Obligation (CMO) tranche designed to have a more predictable cash flow and average life over a range of prepayment speeds, due to the presence of companion (support) tranches.
- Offers protection against both extension and contraction risk.
- Lower yield than companion tranches due to lower risk.
- Suitable for investors seeking stable cash flows.
Memory trick: CMO tranches are like a river with different currents; some are calm, some are wild.