What was the motivation for the creation of PAC bonds?

What will be an ideal response?

The motivation for the creation of PAC bonds was to diminish the uncertainty in cash flows including prepayment risk. More details are supplied below.

The CMO innovations attracted many institutional investors who had previously either avoided investing in mortgage-backed securities or allocated only a nominal portion of their portfolio to this sector of the fixed-income market. Although some traditional corporate bond buyers shifted their allocation to CMOs, a majority of institutional investors remained on the sidelines, concerned about investing in an instrument that they continued to perceive as posing significant prepayment risk because of the substantial average life variability, despite the innovations designed to reduce prepayment risk.
Potential demand for a CMO product with less uncertainty about the cash flow increased in the mid-1980s because of two trends in the corporate bond market. First was the increased event risk faced by investors. The second trend was a decline in the number of AAA rated corporate issues. Traditional corporate bond buyers sought a structure with both the characteristics of a corporate bond (either a bullet maturity or a sinking fund type of schedule of principal repayment) and high credit quality. Although CMOs satisfied the second condition, they did not satisfy the first.

In March 1987, the M.D.C. Mortgage Funding Corporation CMO Series 0 included a class of bonds referred to as stabilized mortgage reduction term bonds; another class in its CMO Series P was referred to as planned amortization class (PAC) bonds. The Oxford Acceptance Corporation III Series C CMOs included a class of bonds referred to as a planned redemption obligation bonds. The characteristic common to these three bonds is that if the prepayments are within a specified range, the cash flow pattern is known.

The greater predictability of the cash flow for these classes of bonds, now referred to exclusively as PAC bonds, occurs because there is a principal repayment schedule that must be satisfied. 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.