Planned Amortization Classes (PACs)
Many investors choose to trade higher returns for more stable investment horizons and cash flows. The planned amortization classes (PACs) were designed with these investors in mind. PACs produce a more stable cash flow by redirecting cash flow from faster-than-expected or slower-than-expected prepayments to "support" or "companion" classes. The PAC investor receives principal payments based upon a predetermined schedule (the PAC schedule) that, through supporting classes, can be maintained within a certain range of prepayment scenarios (the PAC band). The "initial" or "stated" PAC band is listed in the offering circular supplement. It is not likely that the underlying securities will prepay at a constant rate within the PAC band. Therefore, the range of prepayment speeds that will maintain the PAC schedule can change from month to month. This is called PAC band drift.
A useful analytical tool for assessing the stability of a PAC tranche is the "effective band", which measures the range of constant prepayment speeds that will maintain the PAC schedule at any point in time. The effective band changes as the supporting classes are retired and the amount of underlying securities that produce principal cash flow decreases.
PAC class stable cash flows translate to a more stable weighted average life and yield-to-maturity than for other REMIC class types. This results in pricing with lower yields than less stable class types, such as sequential pay classes, with similar weighted average lives. PAC classes whose support classes have been eliminated by faster-than-expected prepayments are known as "busted" PACs and are similarly priced as sequential pay classes.
A PAC class is characterized by a specific principal payment schedule (much like a sinking fund on a corporate bond). In allocating principal paydowns from the collateral to the REMIC classes, priority is given to meeting the PAC principal schedule; thus, other classes in the deal, termed support or companion classes, absorb prepayment variations as much as possible. PAC classes essentially remove maturity uncertainty, provided prepayments stay within a given range. As might be expected, companion classes typically have a high degree of weighted average life sensitivity to prepayment changes and tend to be priced at higher yields.
A PAC class's degree of prepayment protection is typically characterized by a PAC band, such as 100% - 300% PSA (Public Securities Association). The PACs principal payment schedule is derived by taking the minimum of the collateral principal payments at two constant speeds; these two speeds constitute the PAC band.
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