What Is a Planned Amortization Class (PAC) Tranche?
A planned amortization class (PAC) tranche is a sub-type of asset-backed security that is designed to protect investors from prepayment risk and extension risk. A planned amortization class tranche is designed to pay according to a primary payment schedule that is created using a range of prepayment speed assumptions (PSA). This range of prepayment speeds is referred to as the PAC collar.
- A Planned Amortization Class (PAC) Tranche is a way of protecting investors in asset-backed securities from prepayment risk.
- PAC tranches accomplish this by using a collar based on a range of prepayment speeds to come up with a steady payment schedule in advance.
- While the PAC tranche reduces prepayment risk, reinvestment risk still remains an issue.
How Planned Amortization Class Tranches Work
Planned amortization class tranches are structured products that offer the most stable cash flow and milestones. The companion tranches in a PAC tranche structure absorb the majority of the prepayment and extension risk. So if the modeling for the product is at all accurate, investors are left with an investment that should perform according to the schedule put down on paper.
The PAC tranche structure, with one low-risk tranche sitting atop other tranches absorbing more risk, is the most common one. Of course, because of the safety a PAC tranche offers, it will have the lowest yields within the structure.
As long as the actual prepayment rate is between a designated range of prepayment speeds, the life of the PAC tranche will remain relatively stable, reducing the risk that payment will be delayed and the life of the instrument extended longer than initially planned. Similarly, this tranche also receives some measure of protection against prepayment risk, which is passed down to other tranches in return for a higher rate of return on those lower tranches. Planned amortization class tranches are sometimes referred to as PAC bonds.
PAC Tranches and CMOs
Planned amortization class tranches, like most structured products, can be applied to a range of investments. The only requirement is that there be some type of payment schedule made up of principal and interest. That said, the term PAC tranche is most strongly associated with collateralized mortgage obligations (CMO) and mortgage-backed securities (MBS). The PAC tranche was popularized through these products, creating bond-like structures out of pools of consumer and commercial mortgages.
The Limits of PAC Tranche Protection
The measure of repayment risk protection, which includes both contraction and extension risk, is limited by the size of the companion bond and the speed of repayment. If the speed of repayment is too slow (below the lower PAC collar), the life of the PAC tranche is extended. If the speed of repayment is too fast (above of the upper PAC collar), the life of the PAC tranche is shortened.
In the case of a contracted lifespan for the PAC tranche, the investor can end up with capital returned in a low-interest environment, thus lowering the overall return for that money even if it is reinvested. In the case of an extended lifespan, the investor likely has capital tied up in a lower-yielding investment when higher-yielding options abound.
PAC Tranche or PAC Bond?
Because the PAC tranche enjoys several layers of protection, it is sometimes called a PAC bond. The term bond and tranche are often used interchangeably, particularly when it comes to CMOs, but originally a bond referred to a single debt, a single debtor and a single debt security, whereas tranches are slices cut out of a large pool of unrelated debts to match certain specifications.