Mortgage-backed securities can be further consolidated into collateralized mortgage obligations (CMOs). CMOs are investment-grade bonds, backed by mortgage-backed securities with a fixed maturity, that separate mortgage pools into different classes, or tranches. Each tranche has a different return profile. A tranche can be principal-only, interest-only, principal-plus-interest, or be subject to some other, more complicated formula.
- Prepayment Risk
By organizing mortgage-backed securities into tranches, CMOs mitigate prepayment risk. You may ask, "What's so risky about prepayment? What's wrong with my debtor paying me back faster than his obligation requires?"
As counterintuitive as it sounds to someone new to debt markets, being paid back early is a bad thing. The following application demonstrates:
Let\'s say you hold a $1,000 bond that pays 12% annual interest. The debtor must pay you back that $1,000 principal on the maturity date, but in the meantime he must also pay you $60 every six months to keep up the interest payments.
Unless inflation exceeds that 12% threshold or other markets have been consistently returning more than 12% on new investments, you do not want to give up those coupon payments. If you really wanted the value of that bond back in a lump sum, you could just sell it of your own volition in the open market. You do not want that timing of the cash flows taken out of your hands just because your debtor decided to prepay. Just like a call feature, prepayment risk can cause any debt instrument to trade at a discount.
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