Let’s say there are 3 classes of investors: tranche A, B and C. Tranche A investors will bear the most prepayment risk and the least interest rate risk.
Why is that?
When the payments come in, the first thing the servicer does is skim off their fee.
Then they pay the coupon payments on all bonds: A, B, and C.
If there’s money left over (and there always is), it goes to pay down the principle on the A tranche bonds, until they’re paid off (and gone).
After the A tranche bonds are paid off, when the payments come in, the first thing the servicer does is skim off their fee.
Then they pay the coupon payments on all (remaining) bonds: B and C.
If there’s money left over (and there always is), it goes to pay down the principle on the B tranche bonds, until they’re paid off (and gone).
After the A tranche bonds and B tranche bonds are paid off, when the payments come in, the first thing the servicer does is skim off their fee.
Then they pay the remaining money on the C bonds, and hope that there’s enough to pay the coupon and the principle.
Tranche A has the most prepayment risk because they get all of the prepayments until their bonds are paid off. And because they have the shortest duration – they have the shortest maturity – they have the least interest rate risk.
Tranche C has the least prepayment risk because they won’t get any prepayments – indeed, they won’t get any principle payments at all – until all of the tranche A and tranche bonds are paid off. They have the longest maturity and risk losing principle if prepayments are very high before the other bonds are paid off, so they have the highest interest rate risk.
Tranch A would have a higher coupon rate to compensate for the relatively higher prepayment risk. Higher coupon rate means lower interest rate risk compared to B and C. I think is another reason.
In general, Tranche A will have the lowest coupon rate and Tranche C the highest. A’s maturity is already quite short, to the prepayment (contraction) risk, while higher than that for B and C, is still quite limited, and A has very little extention risk. C’s extension risk, on the other hand, can be substantial.
I disagree with this. Prepayment order here is A, B and C. I don’t see the logic in settling for a lower coupon on A when you are accepting more risk(of prepayment).
I recall from memory an actual example that mortgaes with more prepayment risk(as described in the question) had higher coupon. Couldn’t find this now but would love a third opinon on this as I may be mistaken. Thanks!
There are more risks than just prepayment: extension risk and risk that you won’t receive the full principle. Tranche A has more prepayment risk, but less extension risk, and essentially no risk of loss of principle (unless there’s a default). In total – in general – tranche A’s risk is the lowest; hence, it generally has the lowest coupon.
Ok the concepts seems clearer in my head now. Thx!
Ok i think I get it. So if I look at this as a pass-through MBS with different tranches A would be least risky in the sense that it would get paid the pricipal earlier. C faces more risk in terms of home owner default since it gets paid principal last and extension risk(drop in prepayments so longer duration).
Does that sound right?
Not only default, but prepayments as well. If the mortgages are paid off early, there will be only, say, 5 years of interest payments, instead of 20 years of interest payments. The C tranche bondholders need the homeowners to pay for 20 years so that they get back all of their principle, as well as their coupons. It’s similar to owning an IO: if the underlying mortgages get paid off early, all of the (remaining, anticipated) interest is gone, and with it, the lion’s share of the principle on the IO bonds.