Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

Z-BONDS AND ACCRETION-DIRECTED TRANCHES

Z-bonds are tranches where the bond coupon is accrued by adding the interest to the face value of the bond. While the term “Z-bond” or “Z” is borrowed from zero-coupon bonds in the government strip market, it is a misnomer, since the bonds have a coupon that is only paid to the investor in cash at the point where the bonds begin paying principal (i.e., when the lockout expires). The interest that normally would be paid to the parent bond during the lockout period is deferred and added to the Z’s principal value in a process called accretion. The interest, in turn, is “directed” to a different bond in the structure. This directed cash flow can either form the principal for an entirely new tranche or be combined with an existing tranche to smooth the cash flow profile.

The logic is illustrated in panels A and B of Exhibit 6.16. The timing of principal and interest cash flows on a locked-out tranche at different prepayment speeds is shown in panel A, while panel B shows the same cash flows converted into a Z-bond (which only pays interest after the lockout expires) and a separate principal cash flow comprised of the Z-bond’s accreted interest. By splitting normal interest-paying bonds into accrual bonds (the Z) and an accretion-directed class, the overall deal execution can be improved by either creating very stable bonds (which trade at narrow spreads) or using the accreted interest to improve the profile of existing tranches to make them ...