Planned Amortization Class Bond

A planned amortization class bond (PAC) is a collateralized mortgage obligation tranche that receives a fixed, contractual principal repayment schedule within a defined range of mortgage prepayment speeds. Companion tranches (often called support or subordinate tranches) absorb all prepayment and extension risk outside that band, allowing PAC investors to enjoy near-certainty about when their principal will be repaid.

The sequential-pay limitation

A sequential-pay CMO addresses duration mismatch by creating tranches of different expected maturities. But for investors with rigid liability schedules—pension funds, insurance companies, banks—even this structure carries unacceptable uncertainty. The actual maturity of a long tranche might swing from 8 years to 20 years depending on whether mortgage prepayment speeds run at 100 per cent, 200 per cent, or 400 per cent of the Public Securities Association baseline assumption.

Planned amortization class bonds solve this by locking in a principal repayment schedule and staffing companion tranches with the job of absorbing all the variability. It’s a form of insurance, though uninsured, funded by the yield differential between PAC and support tranches.

How the lock-in works

A PAC tranche is designed with a principal schedule that remains constant as long as mortgage prepayment speeds stay within a pre-defined corridor—typically 100 per cent to 400 per cent of PSA speeds, though wider or narrower bands exist. This means that if actual speeds run anywhere from very slow to quite rapid, the PAC holder receives the exact same principal on the exact same dates.

If prepayments run slower than the slow edge of the band, companion tranches extend (they wait longer for principal), but the PAC’s schedule does not shift. If prepayments accelerate beyond the fast edge, companion tranches shorten dramatically, and the PAC again maintains its schedule. The companion tranches are the shock absorbers.

The prospectus for a PAC deal explicitly states its amortization schedule: month 1 receives $X principal, month 2 receives $Y, and so on for the life of the deal. This is as close to a guarantee as mortgage-backed securities ever get (barring default, which is rare in PAC deals because most are backed by agency mortgages or private-label mortgages of very high credit quality).

The companion tranche trade-off

Companion tranches—sometimes called support tranches or subordinate tranches—are the price of this certainty. They receive no principal if the PSA speed is at the slow edge of the PAC band. All principal beyond the slow-side assumption goes to companions. If speeds are at the fast edge, companions receive nothing; all the prepayment upside belongs to the PAC.

Mathematically, the companion tranches “take all the bullets” for prepayment variability. In a sequential-pay CMO deal, the difference between fast and slow prepayment scenarios might mean a long tranche’s maturity moves from 10 years to 18 years. In a PAC deal, the PAC matures in exactly 10 years across that full range, but the companion tranches might mature in 3 years (fast scenario) or 25 years (slow scenario). The companion risk is extreme—and their yield must be substantially higher than the PAC’s to compensate.

Who needs PACs?

Pension funds and life insurance companies are the classic buyers. They have long-dated liabilities (pension obligations payable in 15 years, life payouts at age 85, etc.) and need to know when principal will arrive. A PAC bond lets them structure an asset-liability matching strategy with certainty. They buy a PAC that matures exactly when a liability comes due, lock in the yield, and sleep soundly.

Banks use PACs for the same reason: to match loan origination revenue to funding maturities. If a bank funds a 10-year auto-loan portfolio with a 10-year PAC bond, cash flows align by design, reducing interest-rate-risk and refinancing-risk.

Retail investors generally avoid PAC companions and stick to PAC tranches themselves, accepting the lower yield for durational certainty.

The yield cost of certainty

PAC tranches carry lower yields than sequential-pay tranches of comparable maturity because the interest-rate-risk is lower. A 10-year PAC might yield 4.2 per cent, while a 10-year sequential-pay tranche with similar credit-risk might yield 4.8 per cent. The difference—the PAC spread—is the investor’s payment for the certainty of principal timing.

Companion tranches, by contrast, often yield 1–2 per cent above comparable sequential-pay tranches because they absorb all the variability. An investor buying a companion is, in effect, selling prepayment-risk and extension-risk insurance to PAC holders.

Breaking the band

The PAC protection is not absolute. If prepayment speeds fall outside the band on the slow side (i.e., if speeds are slower than the low-end assumption), the PAC schedule can start to slip. Similarly, if speeds are much faster than the high-end assumption, all available principal might not be enough to maintain the PAC schedule. In real life, bands are wide enough that this is rare, but prospectuses disclose the assumption range, and the possibility of “slippage” is acknowledged.

During periods of extreme interest-rate volatility—such as the 2008 financial crisis or the sharp rate swings of 2022–2023—some PAC deals have experienced deviations from their planned schedules, though the insulation is typically effective for 95 per cent of market scenarios.

Variations and refinements

The PAC concept has spawned refinements. Very accurately planned (VAP) tranches tighten the prepayment band even further, offering even more certainty. Notional interest-only (IO) strips and principal-only (PO) strips are derivatives of the same mortgages used in PAC deals. Z-bonds (accrual tranches) can be issued alongside PAC tranches, deferring all interest until senior tranches retire.

The essential principle remains: use support tranches to buy certainty for the PAC investor. The wider the prepayment band and the more generous the support tranche buffer, the more locked-in the PAC schedule becomes.

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