A PAC tranche, short for Planned Amortization Class tranche, is a bond within a collateralized mortgage obligation that pays principal back to investors on a preset schedule, provided the mortgages underlying the deal prepay at speeds inside a defined range called the collar. Companion bonds known as support tranches absorb any prepayment activity outside that range, which is what keeps the PAC on its schedule. The trade-off is yield: PAC tranches pay less than the riskier classes in the same deal because their cash flows are far more predictable.
How the Scheduled Payments Are Built
Every CMO starts with a pool of residential mortgages whose payments are sliced into different bond classes. Borrowers in the pool make monthly principal and interest payments, but nobody knows exactly when any given loan will pay off or refinance. A PAC tranche imposes order on that uncertainty by fixing a specific timetable for returning principal.
The timetable is built from two prepayment scenarios, a slow one and a fast one. Analysts run the mortgage pool through each scenario separately, producing two amortization schedules. For each period, the PAC’s scheduled payment is set at the lower of the two principal amounts. The resulting path works under either extreme and everything in between.
Prepayment speeds are typically quoted using the PSA model, originally developed by the Public Securities Association (now part of SIFMA).1Investopedia. PSA Standard Prepayment Model: A Guide for Investors in MBS A collar written as “100% to 300% PSA” means the deal was modeled at those two speeds and the PAC schedule should hold anywhere in that range. Multiples above 100% describe faster prepayment environments; multiples below describe slower ones.
How the Collar Protects You
The collar is the heart of the structure. It defines the band of prepayment speeds within which the PAC receives its scheduled principal and nothing more. As long as actual prepayments stay inside that band, the tranche’s average life and duration remain relatively stable.2Investopedia. Planned Amortization Class (PAC) Tranche – Section: The Limits of PAC Tranche Protection
When prepayments run faster than the PAC schedule needs, the surplus principal flows to the support tranches rather than to the PAC. The PAC investor is not forced to reinvest early at whatever rate the market is offering. When prepayments slow down, the support tranches are pushed to the back of the line and all available principal is directed to the PAC first, keeping it on schedule even though the pool as a whole is generating less cash than expected.
The width of the collar depends on two things: the PSA speeds chosen during structuring and the size of the support tranches relative to the PAC class. A deal where support tranches make up 40% of the total principal gives the PAC a wider, more durable collar than one where support tranches are only 15%. Wider collars mean stronger protection but smaller PAC classes.
Inside the collar, a PAC tranche shows positive convexity: its price reacts more symmetrically to rate changes than a plain mortgage pass-through. Outside the collar, it reverts to the negative convexity typical of mortgage-backed securities, where price gains from falling rates are capped by faster prepayments and price losses from rising rates are amplified by slower ones.
The Collar Narrows as the Deal Ages
The collar printed in the original prospectus does not stay constant. As the deal ages and support tranches pay down, the remaining support balance shrinks, and with it the capacity to absorb future prepayment swings. A deal originally structured with a 100–300% PSA collar might operate with a tighter effective range of 150–250% PSA a few years in, depending on how prepayments have tracked.
This drift matters if you are buying in the secondary market. The collar on the original deal sheet tells you where protection started; the current support tranche balance tells you where it actually stands. Trustee reports for CMO deals publish that balance monthly.
Support Tranches Do the Absorbing
Support tranches, also called companion bonds, exist to make PAC tranches work. They are the residual claimants on principal. When the pool generates more principal than the PAC needs, support tranches soak it up. When the pool generates less, they get nothing until the PAC is satisfied. Most of the prepayment and extension volatility in a CMO deal ends up concentrated in these classes.
The compensation is yield. Support tranches carry higher coupons than PACs in the same deal because investors demand a premium for absorbing timing uncertainty. A support tranche might return principal in three years or fifteen, depending on how rates move. The relationship with the PAC is zero-sum in a useful sense: every dollar of stability the PAC investor enjoys comes at the expense of the support holder.
When a PAC Gets “Busted”
PAC protection is not permanent. If prepayments run faster than the upper collar for a sustained period, the support tranches can be paid off completely. Once the support balance hits zero, nothing is left to absorb excess principal. The PAC then receives the full, unfiltered cash flows from the pool and behaves like a sequential CMO bond with no special protection.3PFM Asset Management. The Ins and Outs of Collateralized Mortgage Obligations
The industry calls this a busted PAC. It loses the predictable amortization schedule that justified its pricing, and its duration and yield calculations become immediately unreliable. An investor who bought the tranche expecting a stable 5-year average life might suddenly face a 2-year payoff in a falling-rate environment or a 10-year drag in a rising one.3PFM Asset Management. The Ins and Outs of Collateralized Mortgage Obligations
The reverse scenario is equally damaging. If prepayments stay well below the lower collar for an extended period, the support tranches have already deferred all they can and there is no additional principal to redirect. The PAC extends past its expected maturity. This extension shows up precisely when it hurts, during rising-rate environments when borrowers have no reason to refinance and the investor is locked into a below-market yield.
Monitoring the support tranche balance is the single most important ongoing task for a PAC holder. That remaining balance is the best real-time gauge of how much protection is left.
PAC I, PAC II, and Related Classes
Some CMO deals include a second tier called PAC II (or Type II PAC). These sit between the PAC I class and the pure support tranches. A PAC II has its own scheduled amortization and its own collar, but that collar is narrower than the PAC I collar. When prepayments move outside the PAC II collar but stay inside the PAC I collar, the PAC II absorbs the volatility so the PAC I stays on track. Yields and cash flow predictability fall between the two.
How PACs Compare to Other CMO Classes
A sequential tranche pays principal to the classes in strict order: the A class receives all principal until retired, then B, then C. Each tranche knows its place in line but has no fixed schedule. A PAC has both priority and a schedule; a sequential tranche has only priority.
A Targeted Amortization Class (TAC) tranche is a one-sided version of a PAC. It sets a scheduled amortization at a single target prepayment speed rather than a collar defined by two speeds.4Nasdaq. Targeted Amortization Class (TAC) Bonds If prepayments come in faster than the target, excess principal is redirected to support tranches and the TAC stays on schedule. If prepayments slow below the target, the TAC has no downside buffer and extends like any unprotected bond. TACs yield more than PACs because the protection is asymmetric.
Support tranches sit at the opposite end from PACs: highest yields in the deal, wildly unpredictable duration.
Yield, Average Life, and Pricing
PAC tranches are typically quoted using yield-to-average-life rather than yield-to-maturity. Because principal returns gradually rather than in a lump sum, the average life captures when, on a weighted basis, the investor gets the money back. A PAC with a stated final maturity of 20 years might have an average life of 7 years because most principal returns in the middle years of the schedule.5Investopedia. Yield-to-Average Life: What It Is, How It Works
For a well-protected PAC with a wide collar and substantial remaining support balance, the average life barely moves across a range of prepayment scenarios. Run the same analysis on a sequential tranche or a companion bond and the average life swings sharply. That stability is what allows portfolio managers to use PAC tranches for liability matching with reasonable confidence.
Tax Treatment
Nearly all CMOs are issued through Real Estate Mortgage Investment Conduits (REMICs). Under federal tax law, a REMIC regular interest is treated as a debt instrument regardless of its economic characteristics, and PAC tranches fall into that category.6Office of the Law Revision Counsel. 26 USC 860B – Taxation of Holders of Regular Interests Income is taxed as ordinary interest, not capital gains.
Holders of REMIC regular interests must use the accrual method for the income even if they otherwise report on the cash method.6Office of the Law Revision Counsel. 26 USC 860B – Taxation of Holders of Regular Interests When a PAC is purchased at a discount to its stated redemption price, the discount is treated as original issue discount and must be accrued into income over the life of the instrument. You may owe tax on income before you receive it in cash. Form 1099-OID reports the accrued amount annually.
Who Actually Buys These
PAC buyers are overwhelmingly institutional. Life insurance companies match long-dated annuity liabilities against assets with stable duration. Pension funds face similar constraints. Banks hold PACs in investment portfolios to manage balance sheet interest rate risk. A portfolio manager with a 7-year liability wants an asset whose effective life stays close to 7 years regardless of what rates do, and PAC tranches deliver that inside the collar.
Individual investors can technically access CMO tranches, but the market is not built for them. Evaluating a PAC requires modeling prepayment scenarios, checking current support balances, and understanding how the effective collar has shifted since issuance. The prospectus contains the collar boundaries, the initial support sizes, and scenario tables showing average life at different PSA multiples. Reading it correctly is the minimum standard for an informed purchase.