Z-Bond

What is Z-Bond?

A Z-bond, also known as an accrual bond, is often the last bond to mature. It receives payment, which is the accrual of interest added to the principal, after all other bond classes.

Understanding Z-Bond

A Z-bond is the last tranche of a collateralized mortgage obligation (CMO). As the last portion of the debt security, it receives payment last. Unlike other tranches of a CMO, a Z-bond does not distribute payments to its holder until all the separate tranches are paid. However, the interest will continue to accrue throughout the life of the mortgage. Thus, when the Z-bond does finally pay off, its holder can expect a hefty sum. The bond will pay both principal and interest.

Z-bonds are categorized as speculative investments and can be risky for investors. A Z-bond is a type of mortgage-backed security (MBS). An MBS is made up of a pool of underlying securities that are usually home mortgages. An MBS is secured only by the lender's confidence in the borrower's ability to make their mortgage payments. 

If a pool of borrowers all default on their mortgage payments, and those mortgages are packaged together into a single CMO, the investor holding a Z-bond for that CMO may lose money. Without the incoming mortgage payments, the bonds cannot be paid off. People who invested in other tranches of the CMO may still make back their initial investment. However, because Z-bonds pay out after all other portions, the Z-bond holder stands to lose the most. Conversely, the inclusion of Z-bonds increases the confidence in the other tranches of the CMO, given that the Z-bonds payments can be applied to satisfy the payment obligations of the other tranches before the Z-bonds obligations.

Minimizing Z-Bond Risk

Most mortgage-backed securities are issued by either a federal agency or by a government-sponsored entity (GSE) such as Fannie Mae and Freddie Mac. Those that are issued by a federal agency are backed by the full faith and credit of the U.S. government. In this way, they can be extremely low risk because they are guaranteed by the U.S. Treasury. 

However, a government-sponsored entity (GSE) does not have U.S. Treasury backing. These entities may borrow money directly from the Treasury, but the government is not obligated to provide funds to bail out these agencies should they find themselves unable to pay their debts. Though these securities carry some risk, that risk is generally considered to be low. For example, during the 2007-08 Financial Crisis, Freddie Mac and Fannie Mae were deemed too big to fail, and the U.S. Treasury stepped in to support their debt. 

A smaller portion of mortgage-backed securities (MBS) comes from private firms, such as investment banks and other financial institutions. These securities should be considered significantly higher in risk, as the U.S. government does not back them. The issuers cannot borrow directly from the U.S. Treasury, should the mortgages default.