What Is Targeted Amortization Class?
Targeted amortization class (TAC) is a type of asset-backed security that is designed to protect investors from prepayment risk. A targeted amortization class tranche is designed to pay according to a defined principal balance schedule that is created using a prepayment speed assumption (PSA). A TAC tranche is similar to a planned amortization class (PAC) tranche in that it protects investors from prepayment, providing steady, stable cash flow and a fixed principal payment schedule. However, targeted amortization class tranches are structured differently than PAC tranches in that they only use one PSA rather than a range, as PAC tranches do.
Understanding Targeted Amortization Class (TAC)
Targeted amortization class tranches are structured products that increase cash flow certainty. TAC tranches can be created with any asset-backed security with a payment schedule, but they are most strongly associated with collateralized mortgage obligations (CMO) and mortgage-backed securities (MBS). The targeted amortization class tranche is essentially a bond under a CMO or MBS. For the TAC tranches, the principal is paid on a predetermined schedule. Any prepayment that occurs is amortized in order to maintain the schedule, stretching the cash flow predictably rather than returning capital in what is likely to be a lower interest environment than when the product was created.
The Relationship between TAC and PAC
As mentioned, a planned amortization class tranche uses a range of prepayment rates, whereas a targeted amortization class tranche uses one. For a PAC, changes in the prepayment rates — either a rise in prepayment or burnout — are baked into the model to some extent. Unlike a PAC holder, a TAC investor will see more or less principal than is scheduled depending upon whether the prepayment rate is higher or lower than the defined rate. For example, if prepayment rates are below the rate used for the TAC, the principal amounts will not be available for scheduled payment, so the life of the TAC will need to be extended. Alternately, the prepayment protection is also limited if the prepayment rate exceeds the PSA used for the TAC. Investors will see their investment returned in what is bound to be a worse interest rate environment.
In fact, the existence of PAC tranches negatively impacts TAC tranches. The PAC tranches are senior to TAC tranches. So, in the hierarchy, PAC tranches yield less and have the lowest risk, TAC tranches yield more than PACs but carry limited protection, and other tranches yield more but carry no protection against prepayment.