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In: Finance

Shortly after you were given this task, you became aware of a new CMO issue that...

Shortly after you were given this task, you became aware of a new CMO issue that has an AA-rated, 7-year Class A VADM tranche, with a 7.00% coupon that uses a Z bond to protect against prepayment and extension risk. Write a second memo to your boss of at least 300 words that offers the following:


What the acronym VADM means in the context of MBS


A description of the new CMO tranche and how it may or may not be a better choice for the client than the corporate bond and the MBS that your boss initially recommended


Solutions

Expert Solution

In the context of MBS (mortgage backed security), VADM refers to Very Accurately Defined Mortgage (VADM) bonds. A VADM is a type of CMO that makes interest payments from the interest which accrues on a Z bond. A Z bond is a zero coupon bond where the interest is accrued at the said rate but is not paid out. Instead the interest is reinvested into the principal amount and is paid out later as part of principal repayments.

A VADM bond comes before the Z bond in the priority structure. Payments in a VADM bond are scheduled within a pre-payment band. The VADM is considered superior as they reduce or eliminate the pre-payment risk to the investors which arises in a falling interest rate scenario. Z bonds are the last classes that repay the principal and since, VADM makes interest payments from interest accruing on the Z bond, the risk against falling interest rates is reduced, thereby protecting the investor against early maturity.

CMO stands for collaterized mortgage obligation which is a type of mortgage backed security (MBS). CMO is a fixed income product and it uses mortgage backed security as a collateral. The new CMO issue has an AA-rated, 7-year Class A VADM tranche, with a 7.00% coupon that uses a Z bond to protect against prepayment and extension risk. Therefore, it would be a better choice for the client than the corporate bond and the mortgage backed security which do not protect against pre-payment and extension risk. This bond is safer than MBS as it provides protection against pre-payment, even if coupon rate may be lower.. Even if interest rates fall in future, there will not only be protection against loss of interest payments but also the possibility to generate some profits.

In conclusion, the CMO is a better option.

jeff jeffy answered 1 year ago
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