Someone please explain this to me (from schweser): ‘‘the accrual bond absorbs most of the prepayment risk in a sequential-pay structure’’ Is the accrual bond that same of the accrual tranche?If so it is last to me paid so shouldn’t it be the other way around? Can someone set me straight on this?
If it is an accrual trach, it won’t reduce prepayment risk, it reduces average life. It basically reallocates the interest payment to other PAC tranches. It won’t absorb any prepayments. This is my understanding from the CFAI book.
But why is the average life being reduced? Can someone please explain? Thanks !
That quote doesn’t make sense. It would make sense if it was a PAC structure. There is no prepayment protection for a sequential pay structure.
What if it’s a sequential-pay CMO, with accrual tranche. Accrual tranche won’t have any effect on prepayments. But it seems that the accrual tranche will reduce the average life of the sequential-pay tranche. But… why???
Well when the accrual tranche pays down there is less protection to the 1st Class in the capital structure. So its avg life could decrease when the supporting classes decrease.
According to LOS 58-i, Say if we have sequential pay tranche A, B, C, D, Z (Accrual), then A will be paid first (highest contraction risk) Z-tranche will be paid at the end. So having a Z-tranche shouldn’t affect how A, B, C and D get their payment back… What am I missing here?
avnx, first of all, you have Z (accrual) which does not pay interest to its holders. However (based on cfa, book5), the interest that should be allocated to the Z tranche goes towards A, B, C, D. The interest of Z is used to pay down the principal of A. bottom line: the averages lives for A, B, C, D shorten vs a sequential without Z. again the reasoning is that the interest that would have been paid to the accrual tranche is allocated to the other tranches.
accural bond’s interest is accuring and increase principal amount and be paid last.
http://www.investinginbonds.com/learnmore.asp?catid=11&subcatid=58&id=35 Copy that picture on the right-hand side into your notes
thx I’ll read this during lunch