A PAC tranche, short for planned amortization class tranche, is a bond carved out of a collateralized mortgage obligation that pays down principal on a fixed schedule so long as the underlying mortgages prepay at speeds inside a defined range called the collar. Companion bonds known as support tranches absorb the swings in prepayment timing on either side of that range. The payoff for the PAC investor is cash flow you can plan around; the cost is a lower yield than the riskier classes in the same deal.
How the Scheduled Payment Path Is Built
Every CMO starts with a pool of residential mortgages whose payments are sliced into different bond classes. Homeowners pay principal and interest each month, but nobody knows when any given borrower will refinance or sell. A PAC tranche imposes order on that uncertainty by locking in a specific dollar amount of principal to be returned each month, regardless of what individual borrowers do, as long as the pool as a whole stays within the collar.
The schedule is constructed from two prepayment scenarios, one slow and one fast. Analysts run the mortgage pool through each scenario separately, producing two amortization schedules. For each period, the PAC’s scheduled principal is set at the lower of the two figures. The resulting path works under either extreme and everything in between.
Prepayment speeds are usually quoted in PSA multiples, a convention originally developed by the Public Securities Association.1Investopedia. PSA Standard Prepayment Model: A Guide for Investors in MBS A collar quoted as “100% to 300% PSA” means the deal was modeled at those two speeds, and the PAC schedule should hold anywhere in that range. Higher multiples mean faster assumed prepayments; lower multiples mean slower.
The Collar and the Support Tranches
The collar is the band of prepayment speeds within which the PAC receives its scheduled principal and nothing more. As long as actual prepayment speeds 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
Support tranches are what make that stability possible. When prepayments come in faster than the PAC schedule requires, the surplus principal flows to the support tranches instead of accelerating the PAC’s payoff. When prepayments slow down, the support tranches get pushed to the back of the line and all available principal is directed to the PAC first. The support classes are the shock absorbers, and they get paid for it: their coupons are higher than the PAC’s in the same deal because they carry all of the timing volatility the PAC sheds. A support tranche might return principal in three years or fifteen, depending on how rates move.
The width of the collar depends on the PSA speeds chosen at structuring and on how large the support tranches are relative to the PAC class. A deal where support tranches represent 40% of principal gives the PAC a wider, more durable collar than a deal where support tranches represent only 15%. Wider collars mean more protection but smaller PAC classes.
The Collar Narrows as the Deal Ages
The collar printed in the prospectus is not fixed. As the deal ages and support tranches pay down, the remaining support balance shrinks, and the effective collar tightens. A deal originally structured at 100–300% PSA might function with a narrower effective range of roughly 150–250% PSA a few years in, depending on how prepayments have actually tracked.
For anyone buying a seasoned PAC in the secondary market, the current support tranche balance matters more than the original collar. The prospectus tells you where protection started; the trustee reports, published monthly, tell you where it stands now.
When the Protection Breaks
PAC protection is not permanent. If prepayments run faster than the upper collar for a sustained period, the support tranches can be paid off entirely. Once the support balance hits zero, nothing is left to absorb excess principal, and the PAC starts receiving the full, unfiltered cash flows from the pool. At that point it behaves like an ordinary sequential bond with no special protection. The industry calls this a busted PAC. Its duration and yield calculations become unreliable overnight. A tranche bought for a stable 5-year average life might suddenly pay off in two years in a falling-rate environment, or stretch to ten in a rising one.3PFM Asset Management. The Ins and Outs of Collateralized Mortgage Obligations
The opposite scenario is equally damaging. If prepayments stay far below the lower collar for long enough, the support tranches have already deferred everything they can, and there is no additional principal to redirect. The PAC extends past its expected maturity, and it happens precisely when it hurts most: rising-rate environments where the investor is locked into below-market yields.
Monitoring the remaining support balance is the ongoing job for a PAC holder. It is the best real-time indicator of how much protection is left, and portfolio managers who ignore the monthly trustee data are the ones who get caught off guard.
Prepayment Risk and Extension Risk
These are the two risks a PAC is designed to blunt. Prepayment risk, sometimes called contraction risk, is that borrowers pay off early when rates fall, leaving the investor to reinvest at lower yields. Extension risk is that borrowers hold onto their existing mortgages when rates rise, trapping the investor’s money at below-market returns for longer than planned. Inside the collar, a PAC addresses both. Outside the collar, the tranche behaves like any other mortgage-backed bond, with the same asymmetric exposure to rate moves.
How PACs Compare to Other CMO Classes
Sequential Tranches
A sequential structure pays principal in strict order: the A class receives all principal until retired, then B, then C. Each tranche has priority in the queue but no fixed schedule. A PAC has both priority and a schedule; a sequential only has priority.
Targeted Amortization Class (TAC) Tranches
A TAC is a one-sided PAC. Its schedule is built at a single target prepayment speed rather than a range.4Nasdaq. Targeted Amortization Class (TAC) Bonds If prepayments come in faster than the target, excess principal is diverted to support tranches and the TAC stays on schedule. If prepayments slow below the target, there is no downside buffer, and the TAC extends like any unprotected bond. TACs yield more than PACs because the protection runs in only one direction.
Support (Companion) Tranches
Support tranches sit at the opposite end of the risk spectrum. They carry the highest yields in the deal and the most unpredictable duration. A refinancing wave can retire them years early; a rising-rate environment can leave them with almost no principal payments for a decade.
PAC II Tranches
Some deals include a second tier called PAC II or Type II PAC tranches. A PAC II has its own schedule and its own collar, but the collar is narrower than the PAC I’s, and the class sits between the PAC I and the pure support tranches in the priority hierarchy. 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 both fall in the middle.
Yield, Average Life, and Tax Treatment
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, average life captures when, on a weighted basis, the investor gets their money back.5Investopedia. Yield-to-Average Life: What It Is, How It Works A PAC with a 20-year stated final maturity might have an average life of 7 years. The value of a well-protected PAC is that this figure barely moves across a range of prepayment scenarios, which is what allows portfolio managers to use these bonds for liability matching.
On tax, 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. PAC tranches fall into that category, so the income is taxed as ordinary interest, not capital gains. Holders must use the accrual method even if they otherwise use cash accounting.6Office of the Law Revision Counsel. 26 USC 860B – Taxation of Holders of Regular Interests If the tranche is purchased at a discount to its stated redemption price, the discount accrues into income as original issue discount over the life of the instrument, reported annually on Form 1099-OID. That can mean owing tax on income not yet received in cash.
Who Actually Buys PAC Tranches
The typical buyer is an institution matching long-dated liabilities. Life insurance companies owe fixed payouts on annuity contracts years out and need assets with cash flow timing that matches. Pension funds face the same constraint. Banks hold PACs in their investment portfolios because stable duration helps manage balance sheet interest rate risk.
Individual investors can access CMO tranches, but the market is overwhelmingly institutional. Evaluating a PAC properly requires modeling prepayment scenarios, tracking support tranche balances, and understanding how the effective collar has shifted since issuance. The prospectus contains the initial collar, the support tranche sizes, and scenario tables showing average life under different PSA multiples. Reading it correctly is the entry price, and it isn’t written for casual buyers.