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Definition: Planned Amortization Class (Pac) Tranche
Planned Amortization Class (PAC) tranche is a class of Collateralized Mortgage Obligation (CMO) that reduces the effects of prepayment risk – the risk that principal amount will be paid ahead of schedule. PAC tranches provide more stable cash flows by reallocating the prepayment risk to other classes or tranches. The payment schedule for a PAC bond is determined on the basis of two prepayment rates which together form a band or collar. A support band ensures that the actual prepayment rate is within this collar by absorbing excess prepayments.
A PAC bond provides protection against extension risk (risk that increasing interest rates causes slower repayment of the principal, leading to an extension in the average life of the investment class) and contraction risk (risk that sustained fast prepayments of the principal lead to the elimination of the support band and result in the principal amount associated with a PAC bond to be exhausted completely).
This protection against extension and contraction risk is due to the fact that PAC bonds specify a prepayment schedule for repaying the principal amount and also have associated support tranches for reallocating the prepayment risk when the prepayment rates are within the collar range. PAC tranches are usually offered at a lower yield as they provide a stable cash flow.
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