Suppose that $1 billion of pass-throughs is used to create a CMO structure with a PAC bond with a par value of $700 million and a support bond with a par value of $300 million

Question

Which of the following will have the greatest average life variability: (i) the collateral, (ii) the PAC bond, or (iii) the support bond? Why?

Answer 1

The support bond will have the greatest average life variability because its purpose is to reduce variability in the cash flows, and thus the variability in the average life, of the PAC bonds. More details are given below.

The average life variability for the collateral should lie between that for the PAC bond and the support bond because the PAC bond class and the support bond class are derived from the collateral. The support bond class is used to create a more stable average life for the PAC bond class. Support bondholders have less priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral.

It is the support bonds that forego principal payments if the collateral prepayments are slow; support bonds do not receive any principal until the PAC bonds receive the scheduled principal repayment. This reduces the risk that the PAC bonds will extend. On the other hand, it is the support bonds that absorb any principal payments in excess of the scheduled principal payment that are made. This reduces the contraction risk of the PAC bonds. The key to the prepayment protection offered by a PAC bond is the amount of support bonds outstanding. If the support bonds are paid off quickly because of faster-than-expected prepayments, there is no longer any protection for the PAC bonds.

Because the stability for the PAC bond comes at the expense of the support bond, the support bond will have more variability in its average life than the PAC bond. Thus, in terms of greatest to least average life variability, we have: the support bond, the collateral, and the PAC bond.