What Is a Companion Tranche?
A companion tranche is a class, or type, of tranche, which is a portion of a debt or security. It is primarily associated as a tranche of a collateralized mortgage obligation (CMO), which also includes planned amortization class (PAC) tranches and targeted amortization class (TAC) tranches. Every CMO that has a PAC or TAC tranche will have a companion tranche. A companion tranche is also known as a “support tranche.”
- A companion tranche is a tranche that makes up part of a collateralized mortgage obligation (CMO).
- The other two tranches of a CMO are a planned amortization class (PAC) tranche and a targeted amortization class (TAC) tranche.
- A companion tranche is considered to be a support tranche to a planned amortization class (PAC) tranche and a targeted amortization class (TAC) tranche.
- Companion tranches absorb the changes in prepayment rates to ensure that the interest and principal payments to the planned amortization class (PAC) tranches and targeted amortization class (TAC) tranches remain stable.
- Because of the volatility in a companion tranche, the yield on a companion tranche is higher than on a PAC or TAC tranche.
Understanding a Companion Tranche
A CMO is a mortgage-backed security that consists of a pool of mortgages that have been repackaged into one financial security offered for sale to investors. Each CMO is organized by maturity and level of risk.
Tranches are portions of a CMO, or other debt or security, structured to divide risk or to group the assets by characteristics. This division and portioning of securities make them customized and marketable to specific segmenets of investors. The analogy given in the case of CMO tranches is the chicken industry and how it evolved to the sale of legs, wings, breast, thighs, fat, etc. Each segment of the market can buy the right parts for the right price. This way, no part of the chicken is wasted by the wrong buyer, and the financial result is maximized for the chicken company.
A CMO that contains a companion tranche is vital because prepayment rates on the underlying securities in a collateralized mortgage obligation (CMO) can change, which in turn affect principal and interest payments to the planned amortization class (PAC) and targeted amortization class (TAC) tranches.
The purpose of a companion tranche is to absorb any changes in mortgage prepayment rates and to keep the principal and interest payments to the PAC and TAC tranches stable.
PAC and TAC tranches have priority in receiving principal and interest payments in a CMO. A collateralized mortgage obligation (CMO) is issued with mortgage prepayment rate assumptions. If the actual prepayment rate differs from these assumptions, the difference is absorbed by the companion tranche.
Changes in prevailing interest rates significantly impact mortgage prepayment rates. When interest rates fall, mortgage prepayments typically increase. Increases in prepayment is due to homeowners refinancing their existing mortgages or purchasing new homes to take advantage of the new lower rates. The prepayments cause a contraction risk with the shortening of the life, or term, of a planned amortization class (PAC) or targeted amortization class (TAC).
Conversely, when interest rates rise, mortgage prepayments typically decrease. Higher rates mean a homeowner will not refinance and be subject to the increase. Also, they may be less apt to move. A decrease in prepayment, in turn, increases the term of PAC or TAC tranches and is called extension risk.
In the simplest instance, borrowers of the mortgages that make up a CMO may pay down their mortgages sooner than expected, which would decrease the principal and interest payments that go into the CMO, which in turn go to the investors as returns. To prevent this from happening, the companion tranche will absorb the decrease in payments while the PAC and TAC tranches remain intact and receive their payments as if nothing occurred to the underlying mortgages.
Risk Protection With a Companion Tranche
A companion tranche protects both planned and targeted amortization class tranches from contraction and extension risk. In turn, the companion tranche maintains the stability of the prioritized payments to PAC and TAC tranches. Excess mortgage principal payments are paid to the companion tranche when prepayments increase. If prepayments decrease, the companion tranche receives no principal payments.
Because of these changes in payments, a companion tranche’s term can vary widely. It will shorten when interest rates are low, and prepayments increase, and lengthen when rates are high, and prepayments decrease. Due to this high degree of variability in the term, the yield on a companion tranche is higher than on a PAC or TAC tranche. A companion tranche may be appealing to an investor who wants higher income and is willing to take more risk of having their principal returned at an undetermined future or earlier time.