Planned Amortization Class (PAC) Tranche: Understanding Its Functionality, Risks, and Applications

A planned amortization class (PAC) tranche is a structured sub-type of asset-backed security designed to mitigate prepayment and extension risks for investors. PAC tranches operate on a predetermined payment schedule derived from a range of prepayment speed assumptions, known as the PAC collar.

Planned amortization class tranches offer investors stable cash flow and predictable milestones. Typically positioned atop other tranches within a structure, PAC tranches absorb minimal prepayment and extension risks compared to companion tranches. This positioning ensures that investors receive scheduled payments as long as the actual prepayment rate falls within the specified range outlined by the PAC collar. However, despite reducing prepayment risk, reinvestment risk remains a concern for investors.

While PAC tranches can be applied to various structured products, they are commonly associated with collateralized mortgage obligations (CMOs) and mortgage-backed securities (MBS). These products utilize PAC tranches to provide investors with structured payment schedules derived from pools of consumer and commercial mortgages.

The protection offered by PAC tranches against repayment risk, including contraction and extension risk, is contingent upon the size of the companion bond and the speed of repayment. If the repayment speed deviates from the specified range outlined by the PAC collar, the lifespan of the PAC tranche may be affected. In scenarios where the repayment speed is either too slow or too fast, investors may face challenges such as lower returns in low-interest environments or capital tied up in lower-yielding investments when higher-yielding options are available.

Due to the multiple layers of protection enjoyed by PAC tranches, they are sometimes referred to as PAC bonds. While the terms “bond” and “tranche” are often used interchangeably, particularly in the context of CMOs, originally, a bond referred to a single debt security, whereas tranches represent slices of a larger pool of debts tailored to specific criteria.

PAC tranches utilize a predetermined payment schedule based on a range of prepayment speed assumptions to mitigate prepayment and extension risks for investors in asset-backed securities.

The PAC collar specifies a range of prepayment speeds within which the actual prepayment rate should fall to ensure the stability of scheduled payments for PAC tranches.

While PAC tranches are commonly associated with CMOs and MBS, they can be applied to various structured products as long as there is a payment schedule comprised of principal and interest.