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Types of Bonds

CMOs Glossary

This section defines terms used in quotes in the text and additional terms that may be helpful to an investor considering an investment in CMOs.

Accretion bond

See “Z-tranche.”

Accrual bond

See “Z-tranche.”

Accrued interest

Interest deemed to be earned on a security but not yet paid to the investor.

Active tranche

A CMO tranche that is currently paying principal payments to investors.

Amortization

Liquidation of a debt through installment payments.

Average life

On a mortgage security, the average time to receipt of each dollar of principal, weighted by the amount of each principal prepayment, based on prepayment assumptions.

Basis point

One-one hundredth (1/100 or .01) of one percent. Yield differences among bonds are stated in basis points.

Beneficial owner

One who benefits from owning a security, even if the security's title of ownership is in the name of a broker or bank (“street name”).

Bid

The price at which a buyer is willing to buy a security.

Bond equivalent yield

An adjustment to a CMO yield which reflects its greater present value, created because CMOs pay monthly or quarterly interest, as opposed to semiannual interest payments on most other types of bonds.

Book-entry

A method of recording and transferring ownership of securities electronically, thereby eliminating the need for physical certificates.

Call risk

For a CMO, the risk that declining interest rates may accelerate mortgage loan prepayment speeds, causing an investor's principal to be returned sooner than expected. As a consequence, investors may have to reinvest their principal at a lower rate of interest.

Cap

The upper limit for the interest rate on an adjustable-rate loan or security.

Clean CMO

See “Sequential-pay CMO.”

CMO (Collateralized Mortgage Obligation)

A multiclass bond backed by a pool of mortgage pass-through securities or mortgage loans. See “REMIC.”

CMT (Constant Maturity Treasury)

A series of indexes of various maturities (one, three, five, seven, or ten years) published by the Federal Reserve Board and based on the average yield of a range of Treasury securities adjusted to a constant maturity corresponding to that of the index.

COFI (Cost of Funds Index)

A bank index reflecting the weighted average interest rate paid by savings institutions on their sources of funds. There are national and regional COFI indexes.

Collateral

Securities or property pledged by a borrower to secure payment of a loan. If the borrower fails to repay the loan, the lender may take ownership of the collateral. Collateral for CMOs consists primarily of mortgage pass-through securities or mortgage loans, although it may also encompass letters of credit, insurance policies, or other credit enhancements.

Companion tranche

A CMO tranche that absorbs a higher level of the impact of collateral prepayment variability in order to stabilize the principal payment schedule for a PAC or TAC tranche in the same offering.

Confirmation

A document used by securities dealers and banks to state in writing the terms and execution of a verbal arrangement to buy or sell a security.

Conventional mortgage loan

A mortgage loan granted by a bank or thrift institution that is based solely on real estate as security and is not insured or guaranteed by a government agency.

CPR (Constant Prepayment Rate)

The percentage of outstanding mortgage loan principal that prepays in one year, based on the annualization of the Single Monthly Mortality (SMM), which reflects the outstanding mortgage loan principal that prepays in one month.

Current face

The current remaining monthly principal on a mortgage security. Current face is computed by multiplying the original face value of the security by the current principal balance factor.

CUSIP number

A unique nine-digit identification number permanently assigned by the Committee on Uniform Securities Identification Procedures to each publicly traded security at the time of issuance. If the security is in physical form, the CUSIP number is printed on its face.

Extension risk

For a CMO, the risk that rising interest rates may slow the anticipated prepayment speeds, causing investors to find their principal committed longer than they expected. As a consequence, they may miss the opportunity to earn a higher rate of interest on their money.

Face value

The par value of a security, as distinct from its market value.

Factor

A decimal value reflecting the proportion of the outstanding principal balance of a mortgage security, which changes over time, in relation to its original principal value. The Bond Buyer publishes the “Monthly Factor Report,” which contains a list of factors for Ginnie Mae, Fannie Mae, and Freddie Mac securities. Fannie Mae, Freddie Mac, and trustees of private-label CMOs also publish CMO tranche factors.

Floating-rate CMO

A CMO tranche which pays an adjustable rate of interest tied to a representative interest rate index such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI).

Floor

The lower limit for the interest rate on an adjustable-rate loan or security.

Hedge

A commitment or investment made with the intention of minimizing the impact of adverse movements in interest rates or securities prices and offsetting potential losses.

Inverse floater

A CMO tranche that pays an adjustable rate of interest that moves in the opposite direction from movements in a representative interest rate index such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI).

IO (interest-only) security

In the case of a CMO, an IO tranche is created deliberately to pay investors only interest and not principal. IO securities are priced at a deep discount to the “notional” amount of principal used to calculate the amount of interest due.

Issue date

The date on which a security is deemed to be issued or originated.

Issuer

An entity which issues and is obligated to pay amounts due on securities.

Jump Z-tranche

A Z-tranche that may start receiving principal payments before prior tranches are retired if market forces create a “triggering” event, such as a drop in Treasury yields to a defined level, or a prepayment experience that differs from assumptions by a specific margin. “Sticky” jump Z-tranches maintain their changed payment priority until they are retired. “Non-sticky” jump Z-tranches maintain their priority only temporarily for as long as the triggering event is present. Although jump Z-tranches are no longer issued, some still trade in the secondary market.

LIBOR (London Interbank Offered Rate)

The interest rate banks charge each other for short-term Eurodollar loans ranging from overnight to five years in maturity.

Lockout

The period of time before a CMO investor will begin receiving principal payments.

Maturity date

The date on which the principal amount of a security is due and payable.

Mortgage

A legal instrument that creates a lien upon real estate securing the payment of a specific debt.

Mortgage loan

A loan secured by a mortgage.

Mortgage pass-through security

A security representing a direct interest in a pool of mortgage loans. The pass-through issuer or servicer collects the payments on the loans in the pool and “passes through” the principal and interest to the security holders on a pro rata basis. Mortgage pass-through securities are also known as mortgage-backed securities (MBS) and participation certificates (PC).

Negative convexity

A characteristic of CMOs and other callable or prepayable securities that causes investors to have their principal returned sooner than expected in a declining interest rate environment or later than expected in a rising interest rate environment. In the former scenario, investors may have to reinvest their funds at lower rates (“call risk”); in the latter, they may miss an opportunity to earn higher rates (“extension risk”).

Offer

The price at which a seller will sell a security.

Original face

The face value or original principal amount of a security on its issue date.

PAC (planned amortization class) tranche

A CMO tranche that uses a mechanism similar to a sinking fund to determine a fixed principal payment schedule that will apply over a range of prepayment assumptions. The effect of the prepayment variability that is removed from a PAC bond is transferred to a companion tranche.

Par

A price equal to the original face amount of a security, as distinct from its market value. On a debt security, the par or face value is the amount the investor has been promised to receive from the issuer at maturity.

Payment date

The date that principal and interest payments are paid to the record owner of a security.

P&I (principal and interest)

The term used to refer to regularly scheduled payments or prepayments of principal and of interest on mortgage securities.

Plain-vanilla CMO

See “Sequential-pay CMO.”

PO (principal-only) security

In the case of a CMO, a PO tranche is created deliberately to pay investors principal only and not interest. PO securities are priced at a deep discount from their face value.

Pool

A collection of mortgage loans assembled by an originator or master servicer as the basis for a security. In the case of Ginnie Mae, Fannie Mae, or Freddie Mac mortgage pass-through securities, pools are identified by a number assigned by the issuing agency.

Prepayment

The unscheduled partial or complete payment of the principal amount outstanding on a mortgage loan or other debt before it is due.

Price

The dollar amount to be paid for a security, which may also be stated as a percentage of its face value or par in the case of debt securities.

Principal

With mortgage securities, the amount of debt outstanding on the underlying mortgage loans.

Private label

The term used to describe a mortgage security whose issuer is an entity other than a U.S. government agency or U.S. government-sponsored enterprise. Such issuers may be subsidiaries of investment banks, financial institutions, or home builders.

Ratings

Designations used by investors' services to give relative indications of credit quality.

Record date

The date for determining the owner entitled to the next scheduled payment of principal or interest on a mortgage security.

REMIC

Real Estate Mortgage Investment Conduit. As a result of a change in the 1986 Tax Reform Act, most CMOs are today issued in REMIC form to create certain tax advantages for the issuer. The terms “REMIC” and “CMO” are now used interchangeably.

Residual

In a CMO, the residual is that tranche which collects any cash flow from the collateral that remains after obligations to the other tranches have been met.

Scenario analysis

Examining the likely performance of an investment under a wide range of possible interest rate environments.

Sequential-pay CMO

The most basic type of CMO, in which all tranches receive regular interest payments, but principal payments are directed initially only to the first tranche until it is completely retired. Once the first tranche is retired, the principal payments are applied to the second tranche until it is fully retired, and so on.

Servicing

Collection and pooling of principal, interest, and escrow payments on mortgage loans and mortgage pools, as well as certain operational procedures such as accounting, bookkeeping, insurance, tax records, loan payment follow-up, delinquency loan follow-up, and loan analysis. The party providing the servicing receives a servicing fee.

Servicing fee

The amount retained by the mortgage servicer from monthly interest payments made on a mortgage loan.

Settlement date

The date agreed upon by the parties to a transaction for the delivery of securities and payment of funds.

Sinking fund

Money set aside on a regular basis, sometimes from current earnings, for the specific purpose of redeeming debt.

SMM (Single Monthly Mortality)

The percentage of outstanding mortgage loan principal that prepays in one month.

Standard Prepayment Model of the Securities Industry and Financial Markets Association

A model based on historical mortgage prepayment rates that is used to estimate prepayment rates on mortgage securities. The Association's model is based on the Constant Prepayment Rate (CPR), which annualizes the Single Monthly Mortality (SMM), or the amount of outstanding principal that is prepaid in a month. Projected and historical prepayment rates are often expressed as “percentage of PSA” (Prepayment Speed Assumptions). A prepayment rate of 100% PSA implies annualized prepayment rates of 0.2% CPR in the first month, 0.4% CPR in the second month, 0.6% CPR in the third month, and 0.2% increases in every month thereafter until the thirtieth month, when the rate reaches 6%. From the thirtieth month until the mortgage loan reaches maturity, 100% PSA equals 6% CPR.

Super PO

A principal-only security structured as a companion bond.

Superfloater

A floating-rate CMO tranche whose rate is based on a formulaic relationship to a representative interest rate index.

Support tranche

See “Companion tranche.”

TAC tranche

Targeted amortization class tranche. A TAC tranche uses a mechanism similar to a sinking fund to determine a fixed principal payment schedule based on an assumed prepayment rate. The effect of prepayment variability that is removed from the TAC tranche is transferred to a companion tranche.

Toggle tranche

See “Jump Z-tranche.”

Tranche

A class of bonds in a CMO offering which shares the same characteristics. “Tranche” is the French word for “slice.”

Transfer agent

A party appointed to maintain records of securities owners, to cancel and issue certificates, and to address issues arising from lost, destroyed, or stolen certificates.

Trustee

An individual or institution that holds assets for the benefit of another.

Weighted average coupon (WAC)

The weighted average interest rate of the underlying mortgage loans or pools that serve as collateral for a security, weighted by the size of the principal loan balances.

Weighted average loan age (WALA)

The weighted average number of months since the date of the loan origination of the mortgages in a mortgage pass-through security pool issued by Freddie Mac, weighted by the size of the principal loan balances.

Weighted average maturity (WAM)

The weighted average number of months to the final payment of each loan backing a mortgage security, weighted by the size of the principal loan balances. Also known as weighted average remaining maturity (WARM) and weighted average remaining term (WART).

Window

In a CMO bond, the period of time between the expected first payment of principal and the expected last payment of principal.

Yield

The annual percentage rate of return earned on a security, as computed in accordance with standard industry practices. Yield is a function of a security's purchase price and interest rate.

Z-tranche

Often the last tranche in a CMO, the Z-tranche receives no cash payments for an extended period of time until the previous tranches are retired. While the other tranches are outstanding, the Z-tranche receives credit for periodic interest payments that increase its face value but are not paid out. When the other tranches are retired, the Z-tranche begins to receive cash payments that include both principal and continuing interest.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.