CMOs: Sequential-Pay, PAC, and Support Tranches

A collateralised mortgage obligation (CMO) takes the cash flows from a mortgage pool (or a pass-through security) and restructures them into multiple tranches with different priorities for receiving principal. The goal is to redirect prepayment risk: some tranches are given greater protection against prepayment uncertainty (at the cost of higher sensitivity for others). The most important CMO structures are sequential-pay tranches (which absorb principal sequentially, creating a range of average lives), planned amortisation class (PAC) bonds (which maintain a stable cash flow schedule across a range of prepayment speeds), and support (companion) tranches (which absorb the prepayment variability that PAC bonds are protected from). IO/PO strips — which separate interest from principal — create the most extreme prepayment exposure of any fixed-income instrument.