PAC Collar
What Is a PAC Collar?
A PAC collar is the range of prepayment speeds, measured by the Public Securities Association (PSA) model, within which the principal repayment schedule of a Planned Amortization Class (PAC) tranche is guaranteed to be met.
A PAC collar is a critical structural feature of a Planned Amortization Class (PAC) tranche within a Collateralized Mortgage Obligation (CMO). It represents a specific range of prepayment speeds—measured against the Public Securities Association (PSA) standard benchmark—under which the PAC tranche's principal repayment schedule will remain constant. Essentially, the collar is the "guarantee" zone. If the underlying mortgages in the pool serve as the engine, the PAC collar is the governor that keeps the output steady, regardless of how fast or slow the engine runs, within reasonable limits. Investors choose PAC tranches specifically for the stability offered by this collar. Mortgage-backed securities (MBS) are notoriously subject to prepayment risk: when interest rates fall, homeowners refinance (prepay), and when rates rise, they stay put (extension). The PAC collar shields the investor from this volatility. The wider the collar (e.g., 50% to 500% PSA), the more protection the investor has against rate fluctuations. Conversely, a narrow collar offers less protection. Understanding the PAC collar is essential for fixed-income investors because it quantifies the safety of the investment's duration. If the collar is breached—a scenario known as "busting the collar"—the PAC tranche loses its schedule stability and begins to behave like a standard sequential-pay bond, exposing the investor to the very risks they sought to avoid.
Key Takeaways
- The PAC collar defines the upper and lower limits of prepayment speeds (e.g., 100% to 300% PSA) that a PAC tranche can withstand while maintaining its scheduled payments.
- It provides a "safety zone" for investors, protecting them from both contraction risk (prepayments too fast) and extension risk (prepayments too slow).
- As long as actual prepayments on the underlying mortgage pool stay within the collar, the PAC tranche behaves like a corporate bond with a stable maturity.
- Companion or support tranches absorb the variability in prepayments outside the collar, shielding the PAC investor.
- If prepayments consistently exceed or fall below the collar limits, the PAC schedule may "bust," and the tranche will revert to paying principal based on actual cash flows.
How the PAC Collar Works
The mechanism of a PAC collar relies on the interplay between the PAC tranche and the or "companion" tranches in the CMO structure. The collar is created by prioritizing the PAC tranche for principal payments according to a schedule derived from the lower and upper bounds of the PSA speeds (e.g., 100 PSA and 300 PSA). When actual prepayments occur: 1. Within the Collar: If the prepayment speed is between the lower and upper bounds (e.g., 150 PSA), the PAC tranche receives exactly the principal scheduled for that month. The support tranches receive any excess principal. 2. Below the Collar (Extension Risk): If prepayments are slower than the lower bound (e.g., 50 PSA), the support tranches defer their principal payments to make up the shortfall for the PAC tranche. The PAC schedule is maintained as long as the support tranches have principal to defer. 3. Above the Collar (Contraction Risk): If prepayments are faster than the upper bound (e.g., 400 PSA), the support tranches absorb the excess principal payments. The PAC tranche still receives only its scheduled amount, and the support tranches get paid off faster. This prioritization continues until the support tranches are completely retired. Once the support tranches are gone, the PAC collar is "busted," and the PAC tranche becomes exposed to the full volatility of the underlying mortgage pool.
Key Elements of a PAC Collar
A PAC collar consists of three main components that define the investment's risk profile: 1. Lower Collar (Extension Protection): This is the minimum prepayment speed (e.g., 100 PSA) used to calculate the schedule. It protects the investor against rising interest rates, which typically slow down refinancing. As long as prepayments don't fall below this rate for too long, the bond won't extend. 2. Upper Collar (Contraction Protection): This is the maximum prepayment speed (e.g., 300 PSA). It protects the investor against falling interest rates and a wave of refinancing. As long as prepayments don't exceed this rate, the bond won't be called early. 3. Support Tranches: These are the shock absorbers. The width and durability of the collar depend entirely on the amount of support bonds outstanding. If the support tranches are small relative to the PAC, the collar is fragile (thin). If they are large, the collar is robust (thick).
Important Considerations for Investors
When evaluating a PAC collar, investors must look beyond the stated range. The "drift" of the collar is a crucial concept. Over time, as prepayments actually occur, the effective collar can shift or narrow. If prepayments have been consistently high (but within the collar), the support tranches are being paid down. This means there is less "cushion" left for future protection against high speeds. Furthermore, the initial collar is based on assumptions made at the time of issuance. If the economic environment changes drastically—such as a historic drop in interest rates—prepayments might spike well beyond the upper collar immediately, potentially busting the PAC structure earlier than anticipated. Investors should assess the current "band" or effective collar, not just the original one found in the prospectus.
Real-World Example: A 100-300 PSA Collar
Consider a newly issued CMO with a PAC tranche that has a stated collar of 100% to 300% PSA. * Scenario A: Interest rates remain stable. The actual prepayment speed of the underlying mortgages hovers around 175% PSA. This is comfortably within the 100-300 range. The PAC investor receives their principal payments exactly as scheduled, yielding a predictable return. * Scenario B: Interest rates drop significantly. Homeowners rush to refinance, and prepayment speeds jump to 450% PSA. This exceeds the upper collar of 300%. Initially, the companion tranches soak up the extra principal. However, if this speed persists, the companion tranches will be paid off quickly. Once they are gone, the PAC tranche will start receiving the massive influx of principal, shortening its life and forcing the investor to reinvest at lower rates (reinvestment risk).
Advantages of PAC Collars
* Predictability: Offers one of the most stable cash flow structures in the mortgage-backed securities market. * Tailored Risk: Allows investors to choose a collar width that matches their risk tolerance. * Yield Pickup: typically offers a higher yield than U.S. Treasuries of comparable duration due to the complexity and residual prepayment risk. * Liquidity: PAC tranches are often the most liquid and actively traded part of a CMO structure.
Disadvantages of PAC Collars
* Lower Yield than Support: Because they are safer, PACs offer lower yields than the support tranches that protect them. * Bust Risk: The protection is not absolute. In extreme rate environments, the collar can fail, altering the investment's characteristics. * Complexity: Understanding the relationship between the collar, the support tranches, and PSA speeds requires sophisticated analysis. * Negative Convexity: Like most MBS, PACs can still exhibit negative convexity if the collar is broken, meaning price appreciation is limited when rates fall.
Common Beginner Mistakes
Investors often misunderstand the limits of the protection.
- Assuming the collar is a permanent guarantee. It is conditional on the existence of support tranches.
- Ignoring the "effective collar." The range changes over time based on past prepayment history.
- Confusing the PSA collar with the coupon rate. The collar refers to prepayment speed, not the interest payout.
- Buying a PAC without checking the "support to PAC ratio." A low ratio means a thin collar and less protection.
FAQs
When a PAC collar is busted, the stability of the tranche is lost. The PAC tranche effectively becomes a sequential-pay bond. If the collar broke due to high prepayments (contraction), the PAC will pay down much faster than scheduled. If it broke due to low prepayments (extension), the average life will extend significantly. In either case, the yield and duration of the investment will deviate from the original expectations.
PSA stands for Public Securities Association (now SIFMA). It is the standard benchmark for measuring prepayment speeds of mortgage-backed securities. 100% PSA assumes a specific curve of prepayment rates over the life of the loan. A PAC collar of 100-300 PSA means the schedule is protected as long as prepayments are between 100% and 300% of that standard benchmark.
PAC collars are considered safer than other CMO tranches (like support bonds or PO strips) because they prioritize principal stability. However, they are not risk-free. They are still subject to credit risk (default of underlying mortgages, though rare in Agency CMOs) and the risk that extreme interest rate movements will overwhelm the support tranches and break the collar.
A wide collar (e.g., 50-500 PSA) offers robust protection against a broad range of economic scenarios, making the cash flows very secure but typically offering a lower yield. A narrow collar (e.g., 150-250 PSA) offers less protection; it is easier to bust, but investors are compensated for this higher risk with a higher yield compared to a wide-collar PAC.
Generally, no. Once the support tranches are retired, they are gone forever. The "shock absorbers" have been removed. Even if prepayment speeds return to the original range later, the structural protection is lost, and the PAC tranche will continue to pay down based on actual cash flows without the buffering effect of the support bonds.
The Bottom Line
The PAC collar is the defining feature of Planned Amortization Class tranches, providing a mechanism to transform volatile mortgage cash flows into a predictable income stream. For fixed-income investors, the collar represents the "sleep-well-at-night" factor, delineating the range of interest rate environments where their investment will perform as expected. While it offers superior protection compared to standard pass-through securities, it is not an absolute guarantee. Investors must monitor the health of the support tranches and understand that in extreme market conditions, even a well-structured collar can break. Ultimately, the PAC collar allows conservative investors to access the higher yields of the mortgage market while mitigating its primary risk: uncertainty.
Related Terms
More in Structured Products
At a Glance
Key Takeaways
- The PAC collar defines the upper and lower limits of prepayment speeds (e.g., 100% to 300% PSA) that a PAC tranche can withstand while maintaining its scheduled payments.
- It provides a "safety zone" for investors, protecting them from both contraction risk (prepayments too fast) and extension risk (prepayments too slow).
- As long as actual prepayments on the underlying mortgage pool stay within the collar, the PAC tranche behaves like a corporate bond with a stable maturity.
- Companion or support tranches absorb the variability in prepayments outside the collar, shielding the PAC investor.