What is a Z-Bond
A Z-bond is a type of bond that 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 of 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.
This type of bond is also known as an accrual bond.
BREAKING DOWN Z-Bond
Z-Bonds can be risky for investors and are speculative investments. The Z-bond is a type of mortgage-backed security (MBS). An MBS is made up of a pool of underlying securities which are usually home mortgages. MBS are only secured 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 packaged together into one CMO, the investor holding a Z-bond for that collateralized mortgage obligations (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. But, because Z-bonds pay out after all other portions, the Z-bond holder stands to lose the most.
Minimizing Z-bonds’ Risk
Most mortgage-backed securities are issued by either a federal agency or by a government-sponsored entity (GSE) such as Freddie Mac and Fannie Mae. 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 these agencies out 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 financial crisis of 2008, 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.