What is a Companion Bond
A companion bond is a class of tranche found in a planned amortization class (PAC) bond that is responsible for protecting the PAC tranche from both contraction and extension risk. The companion bond absorbs excess principal payments during times of high prepayment speeds and defers receiving principal payments during times of low prepayment speeds.
BREAKING DOWN Companion Bond
In periods of high prepayment speeds, the companion bond takes as much of the excess prepayments from the PAC tranche as possible and uses them to repay its own principal amount. Once its portion of the principal is completely paid off, all excess principal payments go back to the PAC bonds. Homeowners tend to prepay their mortgages at higher speeds during periods of low or declining interest rates which allow them to refinance at more favorable rates.
Conversely, in situations of low prepayment speeds, the companion bond, also known as a support tranche or companion tranche, defers the reception of any payments. The principal payments then go toward paying off the PAC bond.
Companion Bonds and Mortgage Securitization
Companion bonds are derived during the securitization of residential mortgages into mortgage-backed securities (MBS). They are a component of a type of MBS called a collateralized mortgage obligation (CMO), where the mortgage pool is carved into separate sections, or tranches, each with different claim against the cash flows of the pool.
Tranches are subordinated by maturity date, interest rate and credit rating. In many cases, rating agencies give the senior most tranche a high investment grade credit rating while rating the junior tranches below investment grade.
Senior tranches – in this case the PAC tranche – are safer than subordinate tranches such as companion bonds. CMO issuers compensate investors with higher tolerance for prepayment and credit risk inherent in higher risk tranches with higher interest rates.
Redistributing the interest and principal payments from the mortgage pool to different tranches broadens the appeal of MBS to a different types of bond investors.
Greater Predictability Provided by Companion Bonds
A principal repayment schedule makes the cash flows for PAC bonds more predictable than other types of CMOs. As long as the prepayment speed stays within the schedule as measured by the designated upper and lower PAC collars, the companion bond will be able to operate. Prepayment protection remains in place as long as the companion bonds are not fully paid off. As companion bonds absorb more or less mortgage prepayments, a new collar can be calculated called the effective collar which covers a wider range of prepayment speeds as the companion bond’s ability to absorb prepayments diminishes over time.