If an investor has a choice between a PAC Tranche and a Support Tranche, at what prepayment speed would an investor be 'better off" with the Support Tranche?
I came across a problem that asked which tranche and investor would choose if interest rates were expected to rise by 1% in the future and expected to stay at this level for an extended period. I understand a PAC tranche would be the appropriate investment choice since the PAC is collared to absorb variations in the prepayment speeds.
So im not sure a situation where an investor would choose the support trance instead of the PAC Tranche? Any ideas or generalities to follow here for the exam?
Tough to tell without the specfic question and understanding the investor’s requirements, but in general if you take the view the increase in rates will extend the life of the security, then you want to purchase bonds that benefit from extension (e.g. premium bonds and IOs).
The question provided an expectation that rates will increase by 1% in the near-term and stay elevated for awhile. It was really vague in genreal but answer choices were PAC tranche, Support or PO.
The support tranche would absorb the extension risk since the PAC is collared so they wouldn’t benefit unless the prepayment speed significantly slowed. It’s not very clear to me at what speed is sufficient to make the support tranche more attractive than the PAC trance.