In a well-protected PAC structure, what would you expect the distribution of the path present values and average lives to be compared to a support bond from the same CMO structure?
What will be an ideal response?
PAC tranches are structured to meet the designs of the investor who prefers a reduction is risk. The greater predictability of the cash flow for PAC bonds occurs because there is a principal repayment schedule that must be satisfied. PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC classes, called support or companion bonds. It is these bonds that absorb the prepayment risk.
Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection. In conclusion, with less risk and uncertainty in a well-protected PAC structure, we would expect the distribution of the path present values and average lives to be more stable compared to a support bond from the same CMO structure.
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