Companion bonds, also known as support or companion tranches, assimilate excess principal payments during high prepayment speeds and defer receipt of principal payments during low prepayment velocities, reducing prepayment risk. They are commonly used in scheduled amortization class and CMO tranches. The bonds’ effectiveness depends on prepayment rates staying within specified levels. Brokers can explain the process to investors, and investors should be familiar with it when acquiring bonds.
Companion bonds are sometimes known as support or companion tranches. The accompanying obligation has the function of assimilating any excess in principal payments when there is a period of high prepayment speed. At the same time, the complementary bonds will function as a means of deferring receipt of principal payments when a period of low prepayment velocity occurs. In both situations, company bonds help reduce the amount of prepayment risk attached to the bond.
One of the most common applications of complementary bonds is found within the scheduled amortization class of bonds. In essence, the bonds work with the PAC bond environment by taking the bulk of the excess CAP tranche prepayments and using the excess to make additional payments on the principal amount of the bond. Once the principal has been paid in full, any overpayments are then applied to the PAC bond issue.
A similar approach occurs with a CMO tranche, as the companion bond process helps settle the principal payment based on the current type of prepayment activity. The goal is to ensure that both the principal obligation and the participating CMO obligation are fully covered in a timely manner.
The function of the complementary bonds depends a lot on how the prepayment process goes. As long as the rate of prepayments stays within the specified upper or lower levels of the involved CAP collar, the bonds will function as intended. However, if other factors enter the picture that make it impossible to maintain the rate of prepayments at either of these extremes, the ability of the companion obligations to work together with the principal obligation is hampered. Fortunately, such circumstances rarely occur.
Brokers who are used to working with bond issues can explain to an investor the relationship between scheduled amortization class bonds and complementary bonds and why the process works so well. While complementary bonds are not automatically part of the structure of all bond issues, the application of bonds associated with the process is not unusual. Any investor looking to acquire bonds should be familiar with the complementary bond process.
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