I have the following in my notes on accrual tranches: Accrual Tranche (Z-bonds): these receive no interest in cash; the coupons are reinvested at the stated rate, which turns those coupons into another chunk of principal that doesn’t start to get paid off until the other tranches have been paid down. This form has no reinvestment risk since the coupons are guaranteed to get reinvested at the rate of the Z-bond, for better or for worse. Instead of getting the interest cash flows, the accrual tranche gets to see their principal balance increase (the interest cash flows get added to their principal balance). Existence of an Accrual tranche has no effect on the prepayment risk felt by other tranches. So what is the point of them, in the context of the MBS? why put them there? do they affect the other tranches in any way? do they affect extension risk somehow? do they affect default risk?
I think they are used after all tranches have been used that’s why it is called accrual tranche, it doesnt help decrease prepayment now, however it is used after all tranches have been used. I hope im right. lol
The portion of principle payment due to z-bond pays to other PACs . So extention risk of PACs reduces. Since int is cumulated in z-bond and net year int is calculated on accumulated value z-bond has little contraction risk. Bottom line Investors averse extension risk go for PACs and those who averse contraction risk go for z-bond.
accruals reduce the risk to the other tranches based on the fact they are the first to receive principal and interest. they reduce extension risk for the senior tranches
I think the reason to include them in structure is to address needs of the clientele looking for zero-coupon bond like payouts.
ok, so long story short; the accrual tranche reduces the other tranches’ extension risk, but has no effect on prepayment risk, and no effect on default risk. this is correct?
default risk is the same for all i believe because that is based on the underlying obligations. the senior tranches have all the prepayment risk because they get principal and interest faster. accruals have the extension risk
Well, a subordinated tranche would protect against default risk
Accrual tranches do not get paid immediately; instead, their interest payments get put towards the senior tranches until those get paid off; principal does not get reduced. This means that the senior tranches get paid off faster, and the accrual tranche holders receive no cash flow until the senior tranches have been paid down to zero. At that point, the accrual tranche (whose cashflows have been used to pay off other bonds and whose principal non-payments have increased the size of principal) gets paid.
IMHO, Accrual Tranche cuts extension risk of other more senior tranches, by taking more of it, but because of this accrual trances also have lower contraction risk. And as far as I understand it, extension and contraction are types of prepayment risks
I can guarantee you that an accrual tranche does not increase prepayment risk. Extension risk is the opposite of prepayment risk.
In my opinion, Role of Accrual tranche in Seq pass thru: Make senior tranches bond life shorter (by adding its interest to the principal repayments of sr tranches) Role of support tranche in PAC situation: It acts as a buffer to facilitate the lower of the prepayment speeds to the sr tranches (130PSA to 90PSA) so the life of certain bonds is more predictable.
prepayment risk broken down into two parts: extension & contraction risks. Accrual tranche helps reduce extension risk and not prepayment risk.
8==D