Describe how the schedule for a PAC tranche is created

What will be an ideal response?

The schedule for a PAC tranche is set so that there will be greater predictability of the cash flow through establishing a principal repayment schedule that must be satisfied. The schedule will be set so that PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC classes, called support or companion bonds. It is these bonds that absorb the prepayment risk. Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.

In setting the schedule, one specifies the amount of the collateral from the pass-through, a coupon rate, a WAC, and a WAM. Given two prepayment speeds (expressed in terms of PSA and called the initial PAC collars), the principal payment or PAC schedule is set. The principal payment consists of the regularly scheduled principal repayment plus prepayments for chosen collateral PSA speeds. The minimum principal payment for the PAC schedule is given by the lower PSA speed (called the lower collar). The characteristic of the collateral allows for the creation of a PAC bond, assuming that the collateral prepays over its life between the two speeds. A schedule of principal repayments that the PAC bondholders are entitled to receive (before any other bond class in the CMO) is specified. Although there is no assurance that the collateral will prepay between the two speeds, a PAC bond can be structured to assume that it will.

The payment rules state (i) how to disburse periodic coupon interest to each tranche on the basis of the amount of principal outstanding at the beginning of the period, and (ii) how to disburse principal payments to tranches based on its schedule of principal repayments. The latter also states which tranches have priority with respect to current and future principal payments to satisfy the schedule. When one tranche is paid off completely, all principal payments are to be made to next tranche specified in the payment rules.

Between the two PSA speeds, the average life for the PAC bond is stable. However, at slower or faster PSA speeds, the schedule is broken, and the average life changes, lengthening when the prepayment speed is less than the lower collar and shortening when it is greater than the upper collar. Even so, there is much greater variability for the average life of the support bond.

Most CMO PAC structures have more than one class of PAC bonds. Given the prepayment speeds chosen, it is possible to make the average life for the multiple PAC bonds less than or greater than that if there was only one class of PAC bonds.