What it means
Mortgage-backed securities bundle home loans and pass the monthly payments through to investors, but homeowners can repay early whenever they refinance or move. That makes the timing of cash flows unpredictable, which is exactly what many institutional buyers do not want.
A collateralized mortgage obligation solves the problem by slicing one pool into several tranches with different rules. The PAC tranche is the protected slice: its principal payments follow a schedule that holds steady as long as prepayment speeds stay inside a range called the PAC band or collar.
The protection is not magic. Every PAC tranche is paired with companion tranches, also called support tranches, which absorb the extra principal when prepayments run fast and go short when prepayments run slow.
Think of the band as a promise with limits. If prepayments stay between, say, 100 and 300 percent of the standard benchmark speed, the PAC pays on schedule, but if speeds break outside the band for long enough, the schedule can shorten or stretch.
Because of that stability, PAC tranches usually offer lower yields than companion tranches from the same deal. Buyers such as pension funds and insurers accept the lower return in exchange for cash flows that line up with their future obligations.
For a non-finance owner, the practical lesson is simple. A PAC tranche is a risk-sharing deal: one investor pays for certainty, and another investor gets paid extra to carry the uncertainty.
In practice
Real-world examples.
Example
A pension fund that must make monthly payments to retirees buys a PAC tranche so the mortgage cash flows arrive on a predictable timetable instead of swinging with refinancing waves.
Example
A regional bank holds the companion tranche of the same deal because it can tolerate lumpy cash flows and wants the higher yield that compensates for absorbing prepayment swings.
Example
When interest rates drop sharply and refinancing accelerates beyond the top of the PAC band, the companion tranche shrinks fast; if it is fully absorbed, the PAC tranche itself can start paying early, a state investors call a broken PAC. Deal documents and trustee reports flag this risk, so buyers watch both the band and the remaining size of the support tranches.
Formula
Calculation
PAC bands are expressed as a range of prepayment speeds, such as 100% to 300% PSA, where PSA is the standard prepayment benchmark. Scheduled principal is paid as planned while actual prepayment speed stays inside that band; outside it, the excess or shortfall flows to the companion tranches until their capacity is used up.
Worked example (simplified, principal only): a deal holds a $200 million pool split into a $120 million PAC tranche and an $80 million companion tranche, and the PAC schedule calls for $2 million of principal in a given month. If the pool produces $5 million of principal that month, the PAC receives its scheduled $2 million and the companion receives the remaining $5 million - $2 million = $3 million.
In a fast month with $9 million of principal, the PAC still receives $2 million and the companion absorbs $9 million - $2 million = $7 million. In a slow month with only $2.5 million, the PAC still receives $2 million and the companion receives $0.5 million. After those three months the companion balance has fallen from $80 million to $80 million - $3 million - $7 million - $0.5 million = $69.5 million, which shows why the PAC is protected only while the companion has balance left to absorb shocks.Case study
Seen in the real world.
This case study is fictional and illustrative. Maple Harbour Insurance, a made-up Canadian life insurer, needs to pay policyholder claims of about 5 million dollars a year starting in five years. Its portfolio manager buys the PAC tranche of a mortgage deal with a 100 to 300 percent PSA collar, because the scheduled principal payments match those claim dates closely.
A hedge fund buys the companion tranche from the same pool at a higher yield. Two years later, mortgage rates fall and refinancing surges past 300 percent PSA, so the companion tranche absorbs the flood of early principal and is retired years early. Maple Harbour keeps receiving its scheduled payments on time, and the fund pockets the extra yield as its reward for taking the prepayment hit.
Watch out
Common mistakes.
- Assuming the payment schedule is guaranteed no matter what; it only holds while prepayments stay inside the band and the companion tranches still have capacity to absorb shocks.
- Ignoring the companion tranches when analysing a deal, because their size and structure determine how much protection the PAC really has.
- Paying too much for stability by accepting a PAC yield that is far below comparable alternatives without checking how wide the band actually is.
Questions
People also ask.
What breaks a PAC tranche?
If prepayment speeds run outside the band long enough that the companion tranches are exhausted, the PAC schedule can no longer be maintained and its payments start arriving earlier or later than planned. That is why sophisticated holders track the support tranches' remaining balance as an early warning signal.
Why does a PAC tranche yield less than other tranches?
Investors pay for certainty. The companion tranche holders earn a higher yield because they agree to absorb the unpredictable part of the mortgage pool's prepayments.
Is a PAC tranche a separate mortgage security?
It is a class within one collateralized mortgage obligation, which itself holds a pool of mortgage-backed securities or loans, so its safety depends on both the underlying mortgages and the deal's structure.
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