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Collateralized Mortgage Obligations (CMOs)

cmos debt instruments fixed income mortgage Aug 17, 2021

Collateralized mortgage obligations (CMOs) are securities that give the bondholder an interest in an underlying pool of Mortgage-Backed Securities, or in some cases pools of mortgages. CMOs are structured so that the individual monthly loan payments are passed through to bondholders, in the form of principal, interest or both, depending upon the class of security, or "tranche," purchased by the investor. CMO tranches are varied and complex and can have a highly predictable payment stream, or a payment stream that may vary widely based upon the movements of interest rates. CMO's should only be purchased if these variables are understood by the investor.

CMOs with the same underlying collateral differ greatly in their prepayment speed and volatility. Although CMOs have a stated maturity, the full repayment of principal could occur well in advance of that date if many homeowners sell their property, refinance their mortgages, default on their mortgages, or prepay the underlying loans faster than scheduled. This lack of payment certainty is referred to as prepayment risk. A typical CMO issue is structured with 10-20 different classes or tranches. Each class can have a different coupon, maturity, and cash flow schedule. This unique structure enables the issuer to transform a pool of 30-year mortgage pass-through securities into a series of bonds each designed to meet the needs of different investor groups.

The issuer predetermines the order in which the classes will be retired. Each month as the cash flow from the underlying collateral is received the trustee will disburse the interest and principal to the classes in a predetermined order. Thereby, principal and interest will be directed to some classes while others will receive interest-only for some period. After the shortest maturity class has been fully retired, the principal will then be directed to the next class in line. This type of structure allows investors in the longer-term classes to enjoy steady interest income for several years as the early classes provide call protection. Thus, prepayment risk does not affect the tranches with longer lives until
the earlier tranches have been retired.

The yield and average life will fluctuate depending on the actual prepayment
experience and changes in current interest rates.

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