Collateralized mortgage obligations may issue special classes of bonds that can either increase or decrease the risks involved in CMO bonds, allowing investors to opt for increased security or the potential of higher returns.
Companion bonds are a special class of CMO bond that is paid off first when the underlying mortgages in a CMO pool are prepaid. Prepayments tend to occur when interest rates fall, so the payment rate on the companion bonds varies with interest rates. As a result, companion bonds absorb much of the prepayment risk in the CMO and display greater volatility on the secondary market. The potential of higher yields is the investor's reward for taking on these risks.
On the other hand, planned amortization class bonds, or PACs, work to reduce risks for investors. Some of the income from the mortgage pools that underlie PACs is diverted into a sinking fund--a special account used to help pay off the PACs. The availability of this sinking fund makes it more likely that the bonds will perform as expected, except in cases of extreme prepayment situations. In return for lower prepayment risk, PACs tend to pay lower interest rates than other classes of CMO bonds.
Strategic Considerations for Collateralized Mortgage Obligations >>