hard · Asset-Backed Securities
Two pari-passu senior bonds are backed by the same static pool of fully-amortizing consumer loans, but the structure splits principal: Bond A receives 100% of scheduled principal until its target balance is met, while Bond B (a planned-amortization-class, PAC) receives principal only within a fixed schedule, with any excess or shortfall absorbed by a support/companion tranche. Prepayments come in far ABOVE the upper pricing speed of the PAC band.
Holding coupons and credit equal, which statement about the realized average lives is correct?
- Bond A's average life shortens sharply with the fast prepayments, while the PAC (Bond B) holds its scheduled average life because the companion tranche absorbs the excess principal, so the PAC exhibits less extension/contraction risk only until the support tranche is exhausted.
- Both bonds shorten by the same amount because they share one pool, so the principal-allocation rules cannot change either bond's average life relative to the underlying collateral.
- The PAC (Bond B) shortens more than Bond A because PACs are first in the principal waterfall whenever prepayments exceed the upper band, accelerating its paydown ahead of the sequential bond.
- Bond A extends while the PAC shortens, because directing all scheduled principal to Bond A first subordinates it to prepayment-driven contraction risk carried by the companion tranche.
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