TARGETED AMORTIZATION CLASS BONDS
A targeted amortization class, or TAC, bond resembles a PAC bond in that both have a schedule of principal repayment. The difference between a PAC bond and a TAC bond is that the former has a relatively wide PSA range over which the schedule of principal repayment is protected against contraction risk and extension risk. A TAC bond, in contrast, has a single prepayment speed from which the schedule of principal repayment is protected. As a result, the prepayment protection afforded the TAC bond is less than that for a PAC bond. As we shall explain, the creation of a bond with a schedule of principal repayments based on a single prepayment rate results in protection against contraction risk but not extension risk. Thus, while PAC bonds are said to have two-sided prepayment protection, TAC bonds have one-sided prepayment protection.
To understand why this is the case, take a simple deal with one TAC (T
) and one support class (S
). Monthly principal cash flows are allocated as follows:
• Pay T to its balance schedule;
• Pay remaining cash flow to S; then
• If S is paid off, pay remaining principal to T.
At prepayment speeds faster than the TAC schedule speed, the TAC has call protection as long as the support bond remains outstanding. At speeds slower than the TAC speed, by contrast, there is not enough monthly principal to meet the TAC’s schedule, causing the average life of the TAC to extend.
There are a number of different structuring variations ...