Z Bond

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	Ads by Contingency Analysis

A Z bond (also called an accrual bond) is a type of bond used in some CMOs. It is often the last bond to mature. It pays no interest while principal is being paid down on earlier bonds. Instead, interest that would have been paid to the Z bond is instead used to more rapidly pay down principal on the earlier bonds. Because it accrues interest rather than pay it out, the Z bond is analogous to a zero-coupon bond.

Cash flows for a CMO with three sequential pay bonds followed by a single Z bond are depicted in Exhibit 1. Note that interest payments made by mortgagors during the early years of the CMO are treated as principal payments to the A, B and C bonds. Principal payments made by mortgagors during the later years of the CMO are treated as payments of accrued interest to the Z bond.

CMO with a Z Bond
Exhibit 1

A Z bond pays no interest while principal is being paid down on earlier bonds.

Z bonds can be incorporated into a variety of CMO structures. Some CMOs have multiple Z bonds that mature one after another. Multiple Z bonds do not need to be consecutive. A CMO might have an intermediate Z bond and a long maturity Z bond with intervening sequential pay tranches. A CMO might consist entirely of Z bonds.