What Is a Z Tranche?
A Z tranche is the lowest-ranked tranche of a collateralized mortgage obligation (CMO) in terms of seniority. Its owners are not entitled to any coupon payments, receiving no cash flow from underlying mortgages until the more senior tranches are retired, or 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."
- A Z tranche is a portion of a structured financial product that only receives payments once all the other tranches have been retired.
- Instead of paying interest to the Z tranche, the money is used to pay off the principal of the upper tranches faster.
- Waiting for everyone else to collect first means holders of Z tranches are the most likely to come up empty.
Understanding a Z Tranche
CMOs, a type of mortgage-backed security (MBS) that contains a pool of home loans bundled together and sold as an investment, are stratified so that the contrasting needs of various investors can be met using the same pool of assets.
Tranches are created to divide up different mortgage profiles into slices that have financial terms suitable for specific investors. 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 cash flow.
At the bottom of the structure is the Z tranche. The Z tranche is mainly used to improve the attractiveness of the tranches above it. The payments that would be going to the Z tranche instead are dedicated to speeding up the maturity of the senior tranches.
Limitations of a Z Tranche
The Z tranche plays a critical role in the creation and long-term success of a CMO, helping to make its senior tranches more secure. That also means that they don't tend to make very attractive investments. Z tranches are described as the riskiest tranche for a reason. It can take decades before an investor sees any money from them, so their holders are up against the time value of money.
Z tranches have average life spans of 18 to 22 years, of which the accrual period is expected to last eight to 10 years, although a prepayment rate above expectations can significantly shorten both.
Waiting for everyone else to collect first comes with several other caveats. As we saw during the Great Recession, homeowners can eventually default on loans. Another big risk that increases over time is outstanding balances on mortgages being paid off ahead of schedule. This phenomenon, known as prepayment risk, prevents MBS holders from recouping all the interest payments they expected to receive as part of their investment.
The volatility that the Z tranche experiences provides additional stability to the upper tranches, making it the ultimate team player within the CMO stratification.
Benefits of a Z Tranche
Despite these flaws, there is a market for Z tranches, indicating that there are people out there who choose to invest in them. These individuals usually have capital on hand and want to park it rather than have to reinvest regularly.
Typical Z tranche investors include those that possess long-term liabilities or those who worry about reinvestment risk, the possibility of being unable to reinvest cash flows at a rate comparable to their current rate of return.