Planned Depreciation Class (PAC)


What is a Planned Depreciation Class (PAC) tranche?

A Planned Amortization Class (PAC) tranche is an asset-backed security subtype designed to protect investors against prepayment risk and expansion risk. A planned depreciation class slice is designed to pay according to a master payment schedule that is created using a range of prepayment rate (PSA) assumptions. This range of prepayment speeds is referred to as the PAC collar.

Key points to remember

  • A Planned Amortization Class (PAC) tranche is a way to protect investors in asset-backed securities against prepayment risk.
  • PAC tranches achieve this by using a tunnel based on a range of prepayment speeds to establish a stable payment schedule in advance.
  • While the PAC tranche reduces the risk of prepayment, the risk of reinvestment remains an issue.

How Planned Depreciation Class Slices Work

Planned Depreciation Class tranches are structured products that offer the most stable cash flows and milestones. The associated tranches in a PAC tranche structure absorb the majority of prepayment and extension risk. So, if the product is modeled accurately, investors are left with an investment that should perform on schedule on paper.

The PAC tranche structure, with a low risk tranche superimposed on other more risk absorbing tranches, is the most common. Of course, because of the security offered by a PAC tranche, it will have the lowest returns within the structure.

As long as the actual prepayment rate is between a designated range of prepayment speeds, the life of the PAC wafer will remain relatively stable, reducing the risk of late payment and longer instrument life more longer than initially expected. Likewise, this tranche also benefits from some protection against the risk of prepayment, which is passed on to the other tranches in exchange for a higher rate of return on these lower tranches. Planned depreciation class slices are sometimes referred to as PAC obligations.

PAC and CMO slices

Planned depreciation class tranches, like most structured products, can be applied to a range of investments. The only requirement is that there be some type of payment schedule made up of principal and interest. That said, the term PAC tranche is most strongly associated with secured mortgage bonds (CMOs) and mortgage backed securities (MBS). The PAC tranche was popularized through these products, creating bond-like structures out of consumer and commercial mortgage pools.

The limits of the protection of PAC units

The extent of protection against repayment risk, which includes both the risk of contraction and expansion, is limited by the size of the additional obligation and the speed of repayment. If the reimbursement speed is too slow (lower than the lower collar PAC), the life of the PAC tranche is extended. If the redemption speed is too fast (above the upper PAC collar), the life of the PAC wafer is shortened.

In the case of a contracted life for the PAC tranche, the investor may end up with returned capital in an environment of low interest rates, thus reducing the overall return on this money even if it is reinvested. In the case of an extended life, the investor likely has capital tied up in a low-yielding investment when higher-yielding options abound.

PAC tranche or PAC bond?

Because the PAC tranche benefits from multiple layers of protection, it is sometimes referred to as a PAC bond. The terms bond and tranche are often used interchangeably, especially when it comes to CMOs, but originally a bond referred to a single debt, a single obligor and a single debt instrument, whereas installments are slices cut from a large pool of unrelated debt. to match certain specifications.

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