Companion bonds, also known as support or companion tranches, help reduce prepayment risk by assimilating excess principal payments during high prepayment speeds and deferring receipt during low speeds. They are commonly used in planned amortization class and CMO tranches. Brokers can explain their relationship to investors.
Companion bonds are sometimes known as support or companion tranches. The complementary bond fulfills the function of assimilating any excess in principal payments when a period of high prepayment speed occurs. At the same time, the complementary bonuses will function as a means of deferring the receipt of principal payments when a period of low prepaid speeds occurs. In both situations, side bonds help reduce the amount of prepayment risk associated with the bond.
One of the most common applications for supplemental bonds is within the planned amortization class of bonds. Essentially, the bonds work with the PAC bond environment by taking as many prepayments from excess PAC tranches and using the excess to make additional payments on top of the principal amount of the bond. Once the principal is paid in full, the overpayments are applied to the PAC bond.
A similar approach takes place with a CMO tranche, in that the ancillary bonus process helps regulate the principal payment based on the current type of prepaid activity. The goal is to ensure that both the main bonus and the assistant CMO bonus are fully covered in a timely manner.
The function of the complementary bonuses depends to a great extent on the way in which the prepaid process proceeds. As long as the speed of the prepayments remains within the specified upper or lower levels of the PAC collar involved, the bonuses will work as intended. However, if other factors enter the picture that make it impossible to maintain the speed of prepayments at either of these extremes, the ability of the complementary bonuses to work in conjunction with the main link is hampered. Fortunately, circumstances of this type rarely occur.
Brokers who are used to working with bond issues can explain to an investor the relationship between planned amortizing class bonds and supplemental bonds, and why the process works so well. Although ancillary bonds are not automatically part of the structure for all bond issuances, the application of ancillary bonds to the process is not uncommon. Any investor wishing to purchase bonds should familiarize themselves with the supplemental bond process.
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