So, from the textbook, it seems that the sequential pay structure is for agency CMOs, and the senior/subordinate tranche structure is for non-agency CMOs. I am wondering if there is any difference between these two? Maybe the tranches in the senior/subordinate structure have different coupon rates since they have different credit risks? Both structures have the equity tranche or the z tranche right?
The Sequential pay structure is a type of CMO, as you said, used to distribute repayment risk based on maturity. Bond with lower maturity faces higher contraction risk (lower extension risk), bond with higher maturity faces higher extension risk (lower contraction risk). These are used for time tranching (I do not see whether junior bonds have higher yields mentioned in Lv1 Curri, please help me to answer).
Senior/subordinate structure is credit tranching (1 type of credit enhancement), used to distribute the credit risk. The most junior will absorb any loss (after credit enhancement loss absorption). Because of the higher credit risk, a higher yield is required for junior bonds (I’m not sure whether they have different coupons, but the yields are definitely different - pls help me to answer this also)
Both of these structures can be used simultaneously because they used to distribute 2 different kinds of risk.
I don’t know if I am understanding it correctly.
So, for Agency MBS, we have time tranching, including the sequential pay structure and PAC. In the sequential pay structure, we have ABC…Z tranches, each tranche has the same yield and receives their interest according to their respective outstanding balance, but principle payments and repayments are used to retire higher tranches first. The Z tranche does not receive interest payments and its interest payment is used to pay off earlier tranches faster and accrued to Z tranche’s outstanding balance. Once all earlier tranches are paid off, Z tranche starts receiving all remaining cashflow and becomes ordinary passthrough security.
For Non-agency MBS, we have credit risk so we have credit tranching, also called senior/subordinate tranching. In this structure, we have senior/subordinate/equity tranches and lower tranches are given higher required yield. The equity tranche does not have a stated yield. All cash inflows generated from the underlying debts, including interests, principal repayments and prepayments are distributed to the senior/subordinate tranches first, and whatever leftover is distributed to the equity tranche.
If my understanding is correct, my only question is: How is the principal distributed in credit tranching scenario? Does it all goes to most senior tranche first?
Basically, I believe that you are correct, however, there are some points I want to mention:
- For Agency MBS (Gennie Mae or other GSE), the credit ratings are so high that they do not need credit enhancement, however, it’s required for Non-agency MBS.
- Time tranching is a characteristic of CMO, not MBS. If CMO which has non-agency MBS as collateral, time tranching exists.
- Cash flow is not distributed to the senior first, but the expected loss is absorbed by the equity tranche first. CFA 1 does not mention how principals are distributed in credit ratings.
- I just read the Fixed Income again and found out that the longer CMO in sequential pay structure might have a higher coupon rate because of longer maturity (maturity premium I believe).
- For ABC…Z tranches, Z is the most junior tranche with the lowest maturity, highest contraction risk (Question 29 of the first Derivatives reading). I’m not sure why the curi mentions that A is the most junior in the example. You can check this in the Deri reading, q29 at the end of the reading.
Needs seniors to confirm my understanding, really appreciate!!!
Yes this question is controversial to everything I have learned…I thought A tranche is the most senior in the sequential pay structure, get paid first, absorb all repayments and prepayments, and has least extension risk, highest contraction risk. I am almost certain that Z tranche is the last one get paid, just search Z tranche in investopedia. Really need someone to clarify this…
I did check various sources, “A tranche is the most senior in the sequential pay structure, gets paid first, absorbs all repayments and prepayments, and has the least extension risk, highest contraction risk, Z tranche is the last one get paid”. This is correct, but I’m not sure why the ABS part in Derivatives reading (from the curriculum) reflects the different things from what I understood (2nd pic)