What Is Z Tranche
Z tranche is the lowest tranche of a collateralized mortgage obligation (CMO) in terms of seniority. The Z tranche is not entitled to any coupon payments, but the interest still accrues and is paid once the more senior tranches are retired (paid off). Instead of paying interest to the Z tranche, the money is used to pay off the principal of the upper tranches faster. In turn, the principal of the Z tranche increases over this time due to the accrued interest. The Z tranche is also written as "Z-tranche" and referred to as the "accrual tranche."
Breaking Down Z Tranche
The Z tranche is mainly used to improve the attractiveness of the tranches above it. The payments that would be going to Z tranche instead are dedicated to speeding up the maturity of the senior tranches. Overall, Z tranche is not a very attractive investment as it could be two decades before the investor sees the money. As such, the Z tranche is up tight against the time value of money, but just because most investors don't want it, doesn't mean there isn't a market. Investors that possess long-term liabilities or those who worry about reinvestment risk would benefit from investing in a Z tranche bond.
The Role of Z Tranche in CMOs
Collateralized mortgage obligations are stratified so that the different needs of many investors can be met using the same pool of assets. The A tranche, for example, may offer short-term income and a shorter time to maturity. The B tranche would then offer a longer time frame of steady cashflow. At the bottom of the structure is the Z tranche, which has to wait for payment and faces more than its fair share of prepayment risk when compared to other tranches. Z tranches have average life spans of 18 to 22 years, of which the accrual period is expected to last eight to 10 years, and a prepayment rate above expectations can significantly shorten both.
Z tranches face a lot of volatility over their lifespans as the mortgage pool goes through its refinancing bouts and refinancing burnout. The volatility that the Z tranche goes through provides additional stability to the upper tranches, making it the ultimate team player within the CMO stratification. So, despite the bottom-of-the-alphabet name, the Z tranche plays a critical role in the creation and long-term success of a CMO. And they do fit the needs of a particular type of investor who has capital on hand and wants to park it rather than have to reinvest regularly.