Hello all! Hows preparation coming along? Can some one please be kind enough to explain to me the tranches and PAC and all that from MBS and ABS as if you were explaining it to a layman?I have studied that maybe 10 times but I dont understand anything apart from “Support tranches have low credit risk but high prepayment risk”
Thanks in advance:)
Ill give it a shot… MBS can have different types of structures, such as PAC and Support tranches, or sequential pay tranches. Basically, the security is divided into “pieces” that allow investors to have exposure to different types of risks, and give them the rights to certain cash flows of the underlying security. Sequential tranches means that the earlier tranches receive any prepayments first. Once the tranche is paid off, the next tranche begins receiving prepayments etc. Therefore, the first tranche has the most prepayment risk, but almost no extension risk. The last tranche has very low prepayment risk (because it wont receive payments until ALL the other tranches are paid off), but has significant extension risk (for the same reason). Prepayments increase when interest rates drop, so early tranches have interest rate risk from decreasing rates. Prepayments slow when rates are high, so later tranches have interest rate risk from increasing rates. Soo if you are a short term investor, you would likely want to avoid extension risk, and buy earlier tranches. Longer term investors avoid prepayments by investing in later or lower tranches. A PAC tranche is a very similar idea, except that the PAC has protection from another tranche called support tranche. This tranche acts as a “shield” to the PAC. As long as prepayments are within a certain band specified in the security, the PAC absorbs all prepayment and extension risk. So if rates drop, the support tranche faces prepayment risk. If rates increase, the support tranche faces extension risk. Another way to say this is that the PAC has scheduled payments, as long as prepayments of the MBS stay within a certain amount. The PAC is able to have this schedule because the support tranche absorbs the risks. If the prepayments fall out of this range (the PAC Collar), then the PAC begins facing prepayment or extension risk. Make sense?
Thanks ! Helpful… they sort of looked the same to me every time I read it , which they are with a slight caveat , which you explained pretty well.
Spanishesk nailed it. I would remember though that credit tranching (having certain bonds absorb the first defaults) is different from pre-payment tranching described above. Many MBS & ABS structures have both credit and pre-payment tranching, with parts of the strcuture absorbing the first pre-payments and different parts of the structure absorbing the first defaults.
So damn good you should be paid!! Thanks a lot. Finally understood this:)