I thought i understood this topic but im still getting a few questions not right. I understand PAC and support; but i dont think i understand Sequential-pay and accrual tranches.I understand acrual tranche get nothing till the end (hence similar to z-bond) and all the interest is accrued; is the accrued interested added to the principal. 1. Do all Sequential-pay structures have accrual tranche? 2. I understand “accrual tranche has no effect on prepayment risk of the structure but shortens the average life of the structure”. could someone explain this?
Where there is prepayment tranching and credit tranching in a sequential-pay who gets paid first and where do defaults go?
the accrual tranche is subject to significant extension risk because they’re effectively last in line. I don’t know why the structure would shorten the average life of the structure?
A sequential-pay structure is like a waterfall. Tranche A is paid first (even receives prepayments) which means they have significant contraction risk but lower extension risk. Tranche B is paid second (receives payments after tranche A is paid off) which means they have contraction risk and extension risk but the degree to which varies.
Regarding 2: Accrual tranches don’t receive any interest payments until the other trances have been paid down. Interest that would have gone to the accrual tranches is used to pay down the principle of other trances, therefore reducing their average life.
Regarding 3: Depends on if theres a Shifting Interest mechanism or not. Without shifting interest the subordinate trances usually absorb prepayments and defaults. With shifting interest, prepayments are diverted to senior trances so that the subordinate tranche retains the same level of credit protection.
Thanks. Could you please explain a little more about shifting interest as i dont seem to get it. Re - prepayments - CFAI mocks says prepayments are paid to senior tranches and defualts do to junior tranches.