We have had a thread about this before but i don’t feel it was resolved. Z tranches receive no payments till the other tranches are paid off. The interest due the accrual is paid to the subordinates. The book says, the accrual tranche protects against reinvestment risk for the trancheholders. the Sauce says that “the accrual bonds absorb most of the prepayment risk in a sequential pay structure.” Logically to me it seems that since the Z reduced reinvestment risk that means it reduces prepayment risk because prepayment would cause one to have to reinvest. Also since the accrual interest is paid toward subordinate principal, why doesn’t it INCREASE prepayment risk to the subs rather than absorbing it?
I have a problem with the second comment, the accrual bonds aren’t absorbing anything. It sounds like they are referring to a PAC support tranche.
I think it may be a question of wording and who’s getting the protection. The first quote means protection for investors in that tranche, not protection for other tranches. Also, I need to look at this again, but I think there may not be a conflict between these two statements. Z tranches avoid interest (like Zero bonds), so they don’t have that particular reinvestment issue, but perhaps their risk of prepayment is increased, which is not inconsistent. True, though, that prepayment risk has to be a form of reinvestment risk - I guess it depends what you’re focusing on - interest or principal. I’m not sure why the Z tranches would absorb prepayment risk in a sequential structure - unless the Sauce means relative to PACs? I need to look at this again, it’s rusty!
Anyone else? I feel like we had better know this one…
I think this is just a translation error. Its hard to debate whats going on without quoting the entire paragraph. The second statement should read, The holder of the Accrual trance is protected against reinvestment risk. The accrual tranche receive no interest or principal. A accrual tranche in a sequential structure would decrease extension risk and increase contraction risk. The people who buy the top trance want this because they are concerned about extension risk. Prepayment risk is composed of both extension and contraction risk. A sequential pay schedule is used to distribute prepayment risk.
accrual tranche has no effect on prepayment risk according to book.
Where ShintreH? All I can find is pp387-388 in book 5. It literally states “thus shorter term tranches and a longer term tranche are created by including an accrual tranche…”