Explain the role of a support bond in a CMO structure

What will be an ideal response?

The support bond class in a CMO structure provides for the prepayment protection for the other bond classes. It is the support bonds that forego principal payments if the collateral prepayments are slow. Support bonds do not receive any principal until the PAC bonds receive the scheduled principal repayment. This reduces the risk that the PAC bonds will extend. Similarly, it is the support bonds that absorb any principal payments in excess of the scheduled principal payment that are made. This reduces the contraction risk of the PAC bonds. Thus the key to the prepayment protection offered by a PAC bond is the amount of support bonds outstanding. If the support bonds are paid off quickly because of faster-than-expected prepayments, there is no longer any protection for the PAC bonds. In fact, if the support bond is paid off, the structure is effectively reduced to a sequential-pay CMO.

The support bonds can be thought of as bodyguards for the PAC bondholders. When the bullets fly (i.e., prepayments occur) it is the bodyguards that get killed off first. The bodyguards are there to absorb the bullets. When all the bodyguards are killed off (i.e., the support bonds paid off with faster-than-expected prepayments), the PAC bonds must fend for themselves: they are exposed to all the bullets.