What type of prepayment protection is afforded a VADM?

Question

What will be an ideal response?

Answer 1

Accrual or Z bonds have been used in CMO structures as support for bonds called very accurately determined maturity (VADM) or guaranteed final maturity bonds. In this case the interest accruing (i.e., not being paid out) on a Z bond is used to pay the interest and principal on a VADM bond. This effectively provides protection against extension risk even if prepayments slow down, because the interest accruing on the Z bond will be sufficient to pay off the scheduled principal and interest on the VADM bond. Thus the maximum final maturity can be determined with a high degree of certainty. If prepayments are high, resulting in the supporting Z bond being paid off faster, however, a VADM bond can shorten.

A VADM is similar in character to a reverse TAC. For structures with similar collateral, however, a VADM bond offers greater protection against extension risk. Moreover, most VADMs will not shorten significantly if prepayments speed up. Thus they offer greater protection against contraction risk compared with a reverse TAC with the same underlying collateral. Compared with PACs, VADM bonds have greater absolute protection against extension risk, and though VADM bonds do not have as much protection against contraction risk, the structures that have included these bonds are such that contraction risk is generally not significant.