What is a Companion Tranche
A companion tranche is a class, or type, of tranche, which is a portion of a debt or security. It is part of a collateralized mortgage obligation (CMO), which also include planned amortization class (PAC) tranches and targeted amortization class (TAC) tranches. Every CMO that has a PAC or TAC tranche will have a companion tranche. A companion tranche is also known as a "support tranche."
BREAKING DOWN Companion Tranche
A companion tranche is vital because prepayment rates on the underlying securities in a collateralized mortgage obligation (CMO) can change, which in turn affect principal and interest payments to planned amortization class PAC and targeted amortization class TAC tranches. Tranches are portions of debt or securities, structured to divide risk or to group the assets by characteristics. This division and portioning of securities make them marketable to investors.
The purpose of a companion tranche is to absorb any changes in mortgage prepayment rates and to keep the principal and interest payments to the PAC and TAC tranches stable. PAC and TAC tranches have priority in receiving these principal and interest payments. A collateralized mortgage obligation (CMO) is issued with mortgage prepayment rate assumptions. If the actual prepayment rate differs from these assumptions, the difference is absorbed by the companion tranche.
Changes in prevailing interest rates significantly impact mortgage prepayment rates. When interest rates fall, mortgage prepayments typically increase. Increases in prepayment is due to homeowners refinancing their existing mortgages or purchasing new homes to take advantage of the new lower rates. The prepayments cause a contraction risk with the shortening of the life, or term, of a planned amortization class (PAC) or targeted amortization class (TAC).
Conversely, when interest rates rise, mortgage prepayments typically decrease. Higher rates mean a homeowner will not refinance and be subject to the increase. Also, they may be less apt to move. Decreases in prepayment, in turn, increase the term of PAC or TAC tranches and is called extension risk.
Companion Trances Provide Risk Protection
A companion tranche protects both planned and targeted amortization class tranches from contraction and extension risk. In turn, the companion tranche maintains the stability of the prioritized payments to PAC and TAC tranches. Excess mortgage principal payments are paid to the companion tranche when prepayments increase. If prepayments decrease, the companion tranche receives no principal payments.
Because of these changes in payments, a companion tranche’s term can vary widely. It will shorten when interest rates are low, and prepayments increase and lengthen when rates are high, and prepayments decrease. Due to this high degree of variability in the term, the yield on a companion tranche is higher than on a PAC or TAC tranche. A companion tranche may be appealing to an investor who wants higher income and is willing to take more risk of having their principal returned at an undetermined future or earlier time.