What it means
When a bank pools thousands of home loans and sells bonds against them, the borrowers' payments are cut into separate slices, called tranches. A TAC tranche is designed so that it is paid down according to a target schedule, as long as the loans in the pool prepay at roughly one chosen speed.
Investors who want a steadier repayment date are the natural buyers. The mechanism is simple.
Each month the pool produces a certain amount of principal from scheduled payments and from borrowers who pay early. The TAC tranche takes what its schedule calls for, and anything extra spills over to a companion tranche that absorbs the surprise.
A TAC is often compared with a PAC (planned amortisation class), but it protects investors from one direction only. It shields the holder from prepayments arriving faster than expected, which is called contraction risk.
It does not protect against prepayments arriving slower, so the bond can last longer than planned, which is called extension risk. Because the protection is one-sided, a TAC usually pays a higher yield than a PAC from the same deal and a lower yield than the companion tranche.
Pricing therefore sits between the two, and the gap reflects how much extension risk the buyer is carrying. Credit risk on the underlying loans is a separate question and depends on who guarantees the pool.
For a non-specialist, the practical lesson is that the label on a bond describes a cash flow rule and not a guarantee. The schedule only holds inside a range of prepayment speeds, and outside that range someone else in the structure takes the strain.
Reading the prospectus for that range is the step that most people skip.
In practice
Real-world examples.
Example
A regional insurance company wants to match a known liability due in about seven years. It buys a TAC tranche because the repayment schedule is more predictable than an ordinary mortgage pass-through bond. The investment manager still models a slow-prepayment scenario to see how late the final payments could run.
Example
A bank structuring a mortgage deal needs to sell a large piece to cautious investors. By designating one slice as a TAC and another as the companion, it makes the TAC attractive to pension funds while the higher-yielding companion goes to hedge funds that accept the volatility. The structure lets the bank sell the whole pool rather than keeping the awkward pieces.
Example
A treasury analyst at a credit union reviews its bond holdings after interest rates fall and homeowners refinance in large numbers. The TAC tranche it owns keeps paying on schedule because the extra principal flows to the companion. Had rates risen instead, the analyst would have expected repayments to slow and the bond's life to stretch.
Formula
Calculation
Principal paid to TAC in a month = the lesser of (principal available from the pool) and (scheduled TAC principal)
Principal paid to companion tranche = principal available from the pool - principal paid to TAC
Suppose the scheduled TAC principal for one month is $1,800,000. In a fast month the pool produces $3,000,000 of principal, so the TAC receives the lesser of 3,000,000 and 1,800,000, which is $1,800,000. The companion tranche receives 3,000,000 - 1,800,000 = $1,200,000. In a slow month the pool produces only $1,500,000, so the TAC receives $1,500,000 and falls short of its schedule by 1,800,000 - 1,500,000 = $300,000, which pushes the bond's repayment further into the future.Case study
Seen in the real world.
Harbourline Savings is an illustrative, fictional lender that packaged $400,000,000 of home loans into a bond deal with three tranches: a TAC, a companion and a residual. The structuring team set the TAC schedule using an assumed prepayment speed that was close to its recent experience with similar borrowers.
For two years prepayments ran near the assumption, and the TAC investors received exactly the principal they expected. Then mortgage rates dropped and refinancing surged, sending far more principal into the pool than the schedule needed. The extra cash went to the companion tranche, which shrank quickly, while the TAC holders were undisturbed.
The illustrative lesson came later, when rates rose and borrowers stopped refinancing. The TAC tranche had no protection against that slowdown, so its average life lengthened and its market price fell more than investors had assumed. Harbourline's sales material had stressed the schedule but had under-explained the one-sided nature of the protection.
Watch out
Common mistakes.
- Treating a TAC as identical to a PAC, when a TAC only protects against faster prepayments and leaves the holder exposed to slower ones.
- Assuming the repayment schedule is guaranteed, when it holds only while the pool prepays at or above the assumed speed.
- Ignoring the companion tranche, which is the part of the structure that actually absorbs the surprise and determines how stable the TAC really is.
Questions
People also ask.
What does TAC stand for in finance?
In this context it stands for Targeted Amortisation Class, a tranche of a collateralised mortgage obligation with a target principal repayment schedule.
Is a TAC safer than an ordinary mortgage-backed bond?
It is more predictable when prepayments are fast, but it still carries extension risk when they are slow, and it carries whatever credit risk the pool has.
Why would anyone buy the companion tranche instead?
The companion pays a higher yield in exchange for absorbing the swings in prepayments, which suits investors who are comfortable with that uncertainty.
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