A Targeted Amortization Class (TAC) is a type of mortgage-backed security (MBS) that possesses a specific structure which provides investors with a predictable stream of cash flows. TACs are designed to offer stability by prioritizing principal payments, thereby minimizing the uncertainty inherent in traditional MBS investments. These securities have gained popularity in the financial industry due to their ability to address the prepayment risk associated with mortgage loans. TACs are typically created by pooling mortgage loans with similar characteristics and structuring them into various classes, each with its own payment priority.
Description:
A Targeted Amortization Class (TAC) is a specialized tranche within a collateralized mortgage obligation (CMO), which is a type of MBS. Unlike traditional MBS, TACs aim to address the risk of prepayment, which occurs when mortgage loan borrowers refinance their loans at lower interest rates, resulting in the early repayment of the principal. Prepayment risk poses challenges for MBS investors, as it affects the expected duration and profitability of their investments. TACs are designed to mitigate this risk by tailoring the cash flow structure to provide more predictable and stable returns.
The creation of a TAC involves grouping mortgage loans with similar characteristics, such as interest rate, maturity, and loan-to-value ratio. These loans are divided into classes, and each class has a specific order of priority for principal repayments. The TAC tranches designed to receive principal payments first are considered to be the most secure, as they have a higher probability of receiving cash flows before the other classes. This payment structure provides investors with an assurance of regular principal payments until a certain target amortization level is achieved.
TACs are often favored by risk-averse investors who seek predictable cash flows. By offering principal protection, TACs provide a level of risk mitigation compared to other MBS securities. However, it is important to note that the predictability of TACs can also hinder potential upside returns during low-interest-rate periods, as borrowers are less likely to refinance in such conditions.
The prioritization of principal payments in TACs allows investors to rely on a more stable stream of cash flows, which can be crucial for institutional investors, pension funds, and other entities with specific liability structures. The targeted amortization structure of TACs helps to manage the risk associated with changes in interest rates, protecting investors from both prepayment risk and extension risk, which occurs when borrowers delay the repayment of principal beyond the anticipated schedule.
In conclusion, a Targeted Amortization Class (TAC) is a specialized type of mortgage-backed security that provides investors with a predictable and stable stream of cash flows. By prioritizing principal repayments, TACs address the prepayment risk inherent in traditional MBS investments. These securities are appealing to risk-averse investors and entities with specific liability structures who seek a reliable investment option in the dynamic field of mortgage finance.
