PAC Bond
 Explained:

Planned amortization class (PAC) bonds are a type of CMO bond. They are designed to largely eliminate prepayment risk for investors. They do this by transferring essentially all prepayment risk to other bonds in the CMO. Appropriately, those other bonds are called support or companion bonds.

PAC bonds offer a fixed principal redemption schedule that will be met so long as prepayments on the underlying mortgage collateral remain within a specific PSA range, which is called a prepayment protection band. To see how this is accomplished, suppose we have a mortgage pass-through which we want to repackage as a CMO with PAC and support bonds. We want the structure's PAC bonds to meet their principal redemption schedule so long as prepayments are between 100% PSA and 250% PSA. The question we must answer is: what principal redemption schedule can we offer and still meet this goal?

Consider Exhibit 1. Its two graphs indicate principal payments—both scheduled payments and prepayments—from our pass-through assuming 100% and 250% PSA.

 Principal Payments Assuming 100% PSA and 250% PSA Exhibit 1 Principal payments—both scheduled payments and prepayment—are indicated for the mortgage pass-through collateral assuming 100% and 250% PSA.

If we superimpose the two graphs, and take the minimum of the two at each point in time, we obtain a principal redemption schedule that can be met so long as prepayments remain between 100% and 250% PSA. This is indicated in Exhibit 2.

 PAC Bond Redemption Schedule Exhibit 2 A principal redemption schedule that is achievable so long as prepayments remain between 100% PSA and 250% PSA is obtained by taking, at each point in time, the minimum principal payment under either 100% PSA or 250% PSA.

Once a principal redemption schedule has been determined as in Exhibit 2, it can be divided among several PAC bonds offering different maturity ranges.

PAC bonds have proven extremely popular since they were introduced in 1986. Various related structures have been devised that offer a form of subordinate prepayment protection. A PAC II bond is formed from the cash flows of support bonds for regular PAC bonds. They offer a fixed principal redemption schedule so long as prepayments remain within another, more narrow, prepayment protection band. They are more risky than PAC bonds but offer higher yields. Continuing on the theme, PAC III bonds are formed from cash flows of support bonds for PAC II bonds.

Super PACs and subordinate PACs are formed by dividing the cash flows of a regular PAC structure into classes offering, respectively, broader and more narrow protection bands. Super and subordinated PACs can be combined in a structure with PAC II bonds. In that structure, the PAC II bonds will be part of the support for the subordinated PAC bonds.

Targeted amortization class (TAC) bonds are analogous to PAC bonds, but are structured differently. They offer one-sided protection, shielding investors from high prepayment rates up to a specified PSA. They do not protect against low prepayment rates. TAC bonds are appealing because they offer higher yields than comparable PAC bonds. The unaddressed risk from low prepayment rates generally does not concern investors as much as risk from high prepayment rates, which the TAC structure does address.