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Definition: Companion Bond
Companion Bond is a tranche of Collateralized Mortgage Obligation (CMO) which is usually present along with Planned Amortization Class (PAC) and Targeted Amortization Class (TAC) bonds which takes the pre payment risk and allows PACs and TACs more cash flow and stability of price. It is also called support bond.
It can also be defined as a tranche which protects another tranche from pre payment risk by taking up a greater share of that risk.
PACs and TACs are CMO bonds i.e. bonds which are mortgage backed securities in which repayments are arranged according to their maturities and risks. They are designed to eliminate pre payment risk of investors. This is done by transferring this risk to other bonds in the CMO. These other bonds are the Companion Bonds.
If an investor purchases PAC or TAC bonds, they ensure less risk and hence, less return. In case f a companion bond, there is greater risk and potential for higher returns.
CMO bonds are first paid when mortgages in a CMO pool are prepaid. Prepayments usually take place when interest rates fall, so payment rates of companion bonds vary with interest rates.
These bonds have more payment risk and hence, greater returns compared to other CMO bonds. If there is a decrease in the interest rates, it causes faster pre- payment of mortgages and the first bond to be redeemed would be the Companion Bond.