DEFINITION of 'Companion Tranche'
A class of tranche found in planned amortization class (PAC) and targeted amortization class (TAC) collateralized mortgage obligations (CMOs) that absorbs variable prepayment rates. The companion trache is so named because it is designed to provide support to the main PAC tranche, which has priority in receiving principal and interest payments so as to give its investors steadier and more predictable cash flows. If the actual rate of prepayments differs from the assumptions made at the time the CMO was issued, the difference is absorbed by the companion tranche.
Also known as a "support tranche".
BREAKING DOWN 'Companion Tranche'
Prepayment rates on CMOs are significantly affected by interest rates. If interest rates fall, prepayments increase because homeowners refinance existing mortgages at lower rates, shortening tranche life; this is known as contraction risk. Likewise, if interest rates rise, prepayments decrease and the tranche life increases, leading to extension risk.
The companion tranche protects the PAC tranche from contraction and extension risk by absorbing excess principal payments when prepayments increase, and deferring receipt of principal payments when prepayments decrease. This means that the term of a companion tranche itself can vary widely, contracting when interest rates are low and prepayments increase, and extending when interest rates are high and prepayments decrease. Due to this high degree of variability in its cash flows and term, the yield on a companion tranche is higher than on a PAC tranche.