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CMO Bonds

Collateralized Mortgage Obligations or CMO's are a series of bonds backed by an agency and their mortgage backed securities. These investments are AAA rated and pay monthly principal and interest.

Collateralized Mortgage Obligations differ from pass through securities in that they have different types of paying bonds within the CMO. There are many types and tranches to evaluate - each with it's own bond risk.

A CMO has different payment timing risk depending on the type of bond you own. Some offer more protection than others from prepayment or extension risk. These bonds have a more predicatable duration to the bondholder vs. a pass through agency bond. Some CMO's can pay off faster than others.

Collateralized Mortgage Obligations are generally meant for institutional investors or wealthy bond investors. The money invested, while earning monthly income - can take a while if interest rates rise. When interest rates rise, a these bonds will pay slower. The refinancing that normally can happen with mortgage pools will slow down or stop when interest rates or bond yields rise.

Principal and Interest Payments

Each CMO tranche has an estimated first payment date on which investors can expect to begin receiving principal payments, and an estimated last principal payment (or maturity ) date on which they can expect their final dollar of principal to be returned. The period when investors receive interest-only payments before principal payments begin in a give tranche is known as the lockout period. The window is the period in which principal repayments are expected to occur. Both first and last principal payment dates are estimates based on prepayment assumptions and can vary according to actual prepayments made on the underlying collateral of the MBS

CMO CASH FLOW PAYMENTS

The monthly cash flow of a CMO is a direct result of the cash flow from the underlying collateral. Along with the monthly interest payments, the MBSs (collateral) also pay some principal. This principal amount is both the regularly scheduled principal payment and any prepayments made by the homeowners. These unscheduled principal payments (over and above the scheduled monthly amortization) happen primarily for two reasons: Interest rates have fallen , and the homeowner chooses to refinance their mortgage at a lower rate, which pays off the original loan; or the homeowner sells the home outright and pays off the mortgage. In either case, this prepayment of principal is passed through the Trust to the CMO bondholders, specifically to the particular Tranche receiving principal at the time of the prepayment.

COLLATERALIZED MORTGAGE AVERAGE LIFE

Once a specific CMO Tranche begins to pay principal, the investors can receive varying amounts of principal each month until maturity. Because of this variability, the term Weighted Average Life (“WAL or average life”) was created to better measure the length of a CMO investment. Average life is the point in time when a 1/2 of the principal investment has been repaid. Therefore, average life is dependent upon the rate of prepayments. If prepayments increase, average life shortens. Conversely, if prepayments decrease, average life lengthens

Types

Plain Vanilla

This is a cmo bond that is set up more simply than others - thus the name "plain vanilla". It spreads the principal and interest payments to all tranches. The principal is apllied to the early tranches first and paying them off the earliest. Plain vanilla Collateralized Mortgage Obligations have prepayment and extension risk.

PAC - Planned Ammortization Class

A PAC Bond or Planned Ammortization Class CMO has more predicatble cash flows and more certainty of final maturity for the investor. A PAC bond has certain protections against pre payment risk or extension risk.

TAC BOND Targeted Amortization Class

A TAC Bond also has scheduled cash flows. However, TACs are designed to remain stable at one PSA speed and faster. TAC Bonds are created to protect against the risk of faster prepayments (“contraction risk”), but typically offer limited protection against slower prepayments (“extension risk”).

Sequential CMO VADM (Very Accurately Defined Maturity)- A VADM has scheduled cash flows within a stated range of prepayments (similar to a PAC Bond). However, a VADM extends this “guaranteed” cash flow schedule all the way down to 0% PSA (no prepayments at all). Therefore, a VADM has no extension risk, and a “very accurate; defined maturity.”

Companion or Support Bond -Support Bonds are the other Tranches within a CMO that contains PAC or TAC Tranches. Support Bonds are dedicated to absorbing excess principal prepayments (under faster PSAs) or giving up needed principal (under slower PSAs) to the PAC or TAC Bonds, in order to maintain scheduled cash flows. Because of the increased cash flow volatility, Support Bonds offer a higher coupon rate and yield than PACs or TACs.

Floater Tranche

Floaters are a variable rate CMO Tranche. Floaters are quoted at a spread to an index (the LIBOR rate, Cost of Funds Index, or Treasury bond CMT) and will adjust periodically up or down as the index moves up or down.

Inverse Floater

The Inverse Floater Tranche of a CMO is also an Adjustable Rate Bond. The Inverse Floater moves in the opposite direction of the stated index. Simply put, if the general level of interest rates goes down, the Inverse Floater’s rate will go up and visa versa.

I.O. (Interest Only Class)

An I.O. receives cash flow exclusively from the interest payments of the underlying Mortgage-Backed Securities (the collateral). An I.O. is purchased at deep discount to face value.

P.O. Principal Only Class

A P.O. receives cash flow exclusively from the principal payments of the underlying collateral. A P.O. is also purchased at a deep discount to face value.

Z BOND A Z Bond is a “Zero Coupon” or accrual Tranche of a CMO. The Z Bond accrues its interest at the coupon rate but instead of the interest paying out to the investor, it is reinvested into the principal balance, and then paid out as part of the principal payments. This provides a “compounded interest” effect on the yield. Z Bonds are purchased at a deep discount to face value.

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