I was wondering if someone could explain this to me. Its from the CFA Fixed Income Textbook, page 388 at the bottom. The accrual tranche has appeal to investors who are concerned with reinvestment risk. Since there are no coupon payments to reinvest, reinvestment risk is eliminated until all other tranches are paid off. -> is this because the accrual tranche doesn’t receive any interest payments… so essentially no reinvestment risk. thank you.
the accrued interest generated from this tranche is used to reduce the outstanding balance of the superior tranches, hence once those are paid in full, the accrual tranche is then paid, the payments to the accrual are at the very end of the life
is accrual tranche only principal repayment? if interest rate falls down, does it mean prepayment risk is high and reinvestment is low?
accrual tranche’s principal repayment amount increases while its interest payments are diverted to the Senior tranches. Once all senior tranches are paid off, it receives both interest and principal for the remainder of its life. Reinvestment risk is avoided on the accrual tranche since no interest is paid on the tranche. So there is no question of reinvestment of the amount till such time it is the only tranche.
thanks, but in your comment, you mention Z tranche receives both interest and principal , you also mentioned no interest is paid on the tranche, very confusing. received the interest definetly have reinvest risk, if interest rate higher, reinvestment risk is huge
z receives both int. and principal AFTER OTHER TRANCHES HAVE BEEN PAID OFF… In the initial phase while it is offering protection to senior tranches - no interest payment, no reinvestment risk . Later it receives both principal and interest payments. (once the senior tranches have been completed). Read the example in the text book (not sure about the page numbers - but there is a numerical example with numbers showing the behavior of an accrual tranche).
Just a crude example francisgy. Would you lend your money to anyone who will never pay it back to you. Will you be happy just by the fact that borrower is not paying any interest or principal, so you dont have any reinvestment risk? No, correct? Similarly, Z tranche is accruing those unpaid interests into principal and will pay only when all other tranches have been paid off.
so can i say Z tranche receives only principal, the interest before game over is given to senior tranche? no re-investment risk, but not happy at the end, z tranche receives the leftover, which includes both interest and principal, very happy. but have re-investment risk because interest rate may be higher.
It is just a matter of preferences. I as an investor may want to lend money and may NOT want to receive any interim payments. Ofcourse, at maturity I will want all accrued interest and principal. And receiving all amount at maturity is not called reinvestment risk. And you as an investor, may want to lend money and want to receive regular cash flows from it. So, you as an investor may want to buy a Senior tranche and i as am investor would want to buy an accrual tranche.
thanks, if you don’t lend the money (without Z tranche), why senior tranche is less protected? without z tranche, senior tranche can still live a very happy life and receive regular cash flow, because subordinate tranche will suffer prepayment, why senior tranche needs additional money from z tranche? after all, the accrual interest will still be paid to z tranche, what better off to senior tranche?
do not look at things from a tranche perspective. tranches are created to “meet the needs of the investors behind the tranches”. Some one is not satisfied with receiving money slowly at the pace that the PAC Bond receives. They want it faster. While another investor wants it slower. PLEASE READ Rus1Bus’s explanation.
Sorry francisgy, maybe i am trying to read too much here, i did not get what you are asking. Nobody is getting anyone’s money. They all have invested money knowing the rules of how they will be paid back. Each of these tranche has different ratings and different payback characterstics. It is upto investors to choose to invest in any of them if at all they are willing to invest.
for the comment: Some one is not satisfied with receiving money slowly at the pace that the PAC Bond receives. They want it faster. While another investor wants it slower. do you mean PAC receives slowly and Z tranche receives faster? Z tranche is the guy who receives the slowest(at the end), why people buy z tranche? again my question is not answered. why senior tranche needs additional money from z tranche? after all, the accrual interest will still be paid to z tranche, what 's benefit to senior tranche using z tranche?
please see the numerical example in the text… also there is a problem in the EOC related to this… see how the principal from Z_tranche moves to the Senior tranche. compare senior tranche in the two examples - one with a straight subordinate tranche, other with the z-tranche, and see how the principal payment window on the PAC tranche changes due to the presence of the z-tranche. Senior tranche in the case where it is a straight subordinate tranche has different investment needs from the senior tranche where a z-tranche is present. Their timing and need for cashflows and their risk appetites are different.
francisgy, I was writing you a message and then my browser shuts off. I come back to see that cpk has written what I was going to. His last paragraph is what you need to understand. I would invest in a particular tranche only if I had some particular view of the interest rate movement and depending on my need of cash flows.
z tranche is there so as to mitigate extension risk for senior tranches. z tranches are there because there are demand for them.
Not to add fuel to this fire but I had a similar question and I figured I’d post it in this thread. EOC question in reading 57, #27 A sequential pay collaterized mortgage obligation (CMO) with an accrual tranche lowers the prepayment risk and shortens the average life of the sequential pay tranches relative to a sequential pay CMO without an accrual tranche. Is this conclusion correct A. Yes B. No, because an accrual tranche increase prepayment risk C. No, because an accrual tranche has no effect on prepayment risk The answer is C: An accrual tranche (Z tranche) is paid only after all other tranches have been paid in full. Thus, a Z tranche acts as a zero coupon, single payment at maturity bond. The existence of an accrual tranche has no effect on prepayments. Now this question is a big confusing, if your looking at it from the perspective of the borrower, thats correct, you could have as many tranches as you want, the prepayment risk would be dependenton interest rate paths. But what I don’t understand is, if you add an accrual tranche (Z-tranche) your rerouting interest payments from the tranche to the other sequential tranches principal, and hence, you get a faster prepayment rate on the sequential tranches effectively increasing Prepayment or contraction risk.
dtrynoski I too got this question wrong, when I had done it. Crucial term to understand is prepayment risk. All in all, interest is diverted from the Z-Tranche to the Sequential CMO tranches. But that is known well before the investor invests in the tranches. Average life on the tranches is lower than what it would have been without a Z-Tranche. But all that is really before the fact. That really has no impact on the Prepayment risk. As you have said above, Prepayment risk is affected by the actual interest rate environment. Interest rate could reduce, More than normal prepayments could occur, and the Sequential CMO tranches could still contract. So there is NO IMPACT on prepayment risk as a result of the Z-Tranche.
I just wanted to note I got this question wrong too, so I wouldn’t be surprised if a similar question showed up on the exam.
That’s a weird question, although I salute cpk for the explanation. The confusion comes from the second part of the question where it says “…relative to a sequential pay CMO without an accrual tranche.”. Also, one tends to think of the Z tranche as a “support” tranche, which it isn’t. So, it seemed to be comparing one structure with a Z and another structure without a Z…sure as hell, I would’ve gotten this wrong!