FI questions -- PAC tranches and Duration understand, collecting, principal, actually

CFA4Techie

Please help to understand two points I've read in the FI topic. Thanks in advance.

1. I saw this statement, "PAC tranches can siphon interest slated for the support tranches, but do not redistribute it. In fact, PAC tranches are designed to provide a minimum guaranteed principal payment by collecting interest targeted for a support tranche when prepayments are low." Does this mean that if prepayments are below expectations, PACs will actually take the interest as well as the principal from support tranches? I thought it was just interest.


2. Please explain why this is true: "Duration and convexity estimates for bonds without embedded options will not be significantly affected by changing the size of the rate shock from 100 basis points to 50 basis points. However, for bonds with embedded options, the size of the rate shock can have a significant effect on the estimates. "

llxx

What I've gathered from the two reponses above is:

1. Yes, not just the support tranche's principal but their interest as well can be held off and sent to the PAC tranches if principal payments are slow.

2. Yield changes --> volatility in rates --> large increases in Vcall and Vput ---> causes large(r) changes in Vcallable bonds. Vnoncallable bonds change as well with changes in yield, but the effect is not as large since it is not impacted by call and put volatility.

Accurate?

RepoToronto

can anyone please confirm?

scarecrow

>
> 1. Yes, not just the support tranche's principal
> but their interest as well can be held off and
> sent to the PAC tranches if principal payments are
> slow.
>
Don't think it is correct. You can only "hold back" the principal. The interest is calculated based on beginning outstanding balance for each tranche.

The promised PAC payment is calculated in advance = MIN CF from principal payment from underlying both in the lower prepayment and higher prepayment schedule, so as long as prepayment is still within this PSA band --> can still afford to pay principal to PAC bond using principal payment from underlying.

You hold back interest only for the Z tranche.


> 2. Yield changes --> volatility in rates --> large
> increases in Vcall and Vput ---> causes large(r)
> changes in Vcallable bonds. Vnoncallable bonds
> change as well with changes in yield, but the
> effect is not as large since it is not impacted by
> call and put volatility.
>
> Accurate?

Think you understand the key points, but you seem to mix between volatility and resulted yield change. Yield can change but volatility does not change necessarily, i.e., change within historical volatility or vice versa, a lot of volatility but no net change, i.e., yield jumps up and down widely but ends up with the same value.

volatility impacts only option-embedded bonds.
Net yield change impacts both. Whether it is more on one vs the other depends on the volatility changes.

iteracom

elcfa Wrote:
-------------------------------------------------------
> >
> > 1. Yes, not just the support tranche's
> principal
> > but their interest as well can be held off and
> > sent to the PAC tranches if principal payments
> are
> > slow.
> >
> Don't think it is correct. You can only "hold
> back" the principal. The interest is calculated
> based on beginning outstanding balance for each
> tranche.
>
> The promised PAC payment is calculated in advance
> = MIN CF from principal payment from underlying
> both in the lower prepayment and higher prepayment
> schedule, so as long as prepayment is still within
> this PSA band --> can still afford to pay
> principal to PAC bond using principal payment from
> underlying.
>
> You hold back interest only for the Z tranche.
>
>
> > 2. Yield changes --> volatility in rates -->
> large
> > increases in Vcall and Vput ---> causes
> large(r)
> > changes in Vcallable bonds. Vnoncallable bonds
> > change as well with changes in yield, but the
> > effect is not as large since it is not impacted
> by
> > call and put volatility.
> >
> > Accurate?
>
> Think you understand the key points, but you seem
> to mix between volatility and resulted yield
> change. Yield can change but volatility does not
> change necessarily, i.e., change within historical
> volatility or vice versa, a lot of volatility but
> no net change, i.e., yield jumps up and down
> widely but ends up with the same value.
>
> volatility impacts only option-embedded bonds.
> Net yield change impacts both. Whether it is more
> on one vs the other depends on the volatility
> changes.

Interesting, I thought all payments (p+i) can be redirected to pay the PAC tranche if prepayments were not meeting expectations.

NO EXCUSES

WarrenB1

bpdolog: i thought so too but it looks like principal and interest can be held off from the supports. the original sentence in the first post is from schweser.

elcfa: i think thats what i meant. yield changes affect both callable and noncallable bonds, but the yield change for a callable bond is exacerbated by the affect of the volatility of the option, which makes the yield change greater for callable bonds.