CFA Level I Exam · Fixed-Income Securitization

Collateralized Mortgage Obligations (CMO) Tranches Explained

Updated 7 October 2026 · Fact-checked

A collateralized mortgage obligation (CMO) splits the cash flows of mortgage pass-throughs into tranches with different priorities. It does not remove prepayment risk. It moves it between tranches. Sequential-pay tranches take principal in order, PAC tranches are protected by support tranches, and support tranches absorb the extra risk.

Understand Collateralized Mortgage Obligations (CMOs)

A mortgage pass-through passes all principal and interest to investors pro rata. Its cash flows are uncertain because homeowners can prepay. When rates fall, prepayments rise (contraction risk). When rates rise, prepayments slow (extension risk). Some investors want short, predictable maturities. Others accept more uncertainty for more yield.

A CMO is built on a pool of pass-throughs (the collateral). It divides the pool's cash flows into tranches. Each tranche gets a different share of principal in a set order. The total risk of the collateral stays the same. The structure only redistributes it, so some tranches become safer and others become riskier.

In a sequential-pay CMO, all principal goes first to Tranche A until it is fully repaid. Then Tranche B receives principal, then C, and so on. Every tranche receives interest on its outstanding balance. Tranche A has the shortest expected life and the greatest contraction risk of the sequential tranches. The last tranche has the longest life and the greatest extension risk. Sequential tranches give investors more predictable maturity ranges, while the total prepayment risk is redistributed, not reduced.

A PAC (planned amortization class) tranche has a schedule of principal payments that holds as long as actual prepayment speeds stay within a band, the initial PAC collar, set by a lower and an upper PSA speed. A support tranche (companion tranche) absorbs prepayment variation: it absorbs excess principal when prepayments are fast (shortening its life) and receives less principal when they are slow (extending its life). So within a given structure, the PAC tranche has the least prepayment risk and the support tranche has the most, and the support tranche pays a higher yield. The PAC has much less contraction and extension risk, but not zero if speeds leave the collar or the support tranches are used up.

PAC and support tranches are layered on top of the collateral, and a structure can also have sequential tranches within the PAC group or the support group. So the risk comparisons above apply within a given structure. Check which structure the question describes before you rank tranches.

Other structures also appear. A floating-rate tranche pays a reference rate plus a spread. An inverse floater pays a coupon that moves opposite to the reference rate. These two are often created together from one fixed-rate tranche. The principal-weighted average of their coupons equals the fixed coupon of that tranche. Both the inverse floater's constant (K) and its leverage factor (L) depend on the split of principal between the two and on the fixed coupon. An accrual (Z) tranche receives no cash interest at first. Its interest is added to its principal balance, and the cash is used to repay earlier tranches. Z tranches shorten earlier tranches, but the Z tranche itself has high extension risk.

Key formulas to remember

Sequential-pay principal rule: All principal → Tranche A until retired; then B; then C; interest paid on each tranche's outstanding balance; Short tranches have contraction risk; the longest tranche has extension risk.
Interest on a tranche: Interest = tranche coupon ÷ 12 × beginning-of-month balance; Use the balance outstanding at the start of the period. Monthly pay is typical.
PAC protection: PAC schedule holds if prepayment speed stays within the collar (lower PSA to upper PSA); The support tranche absorbs variation. If support tranches are exhausted, PAC protection fails.
Floater and inverse floater coupons: Floater coupon = reference rate + spread; Inverse floater coupon = K − L × reference rate. With a zero spread: L = floater principal ÷ inverse floater principal, and K = C × (1 + L), where C is the fixed coupon of the underlying tranche.; K and L both depend on the principal split and on the fixed coupon C. With L set this way, the reference rate cancels out in the principal-weighted average, so the weighted average coupon of the floater and inverse floater equals C. Example: C = 6%, floater $40 million, inverse floater $20 million. L = 2 and K = 18%. Weighted average = (40 × R + 20 × (18% − 2R)) ÷ 60 = 6%.
Risk conservation: Total prepayment risk of the CMO = prepayment risk of the collateral; A CMO redistributes risk. It does not eliminate it.

How to solve Collateralized Mortgage Obligations (CMOs) questions

Use this approach for any CMO question. First identify the tranche type, then check the prepayment direction and who absorbs the effect.

1Identify the tranche type: sequential, PAC, support, floater, inverse floater or accrual (Z).
2Decide the rate environment: falling rates raise prepayments, rising rates slow them.
3Ask where principal goes first. In a sequential structure, it goes to the earliest tranche still outstanding.
4For a PAC, check whether prepayment speed is inside the collar. If yes, the PAC follows its schedule and the support tranche absorbs the difference.
5Name the risk each tranche faces: contraction (short tranches, prepayments fast) or extension (long tranches, prepayments slow).
6Compare tranches: the support tranche has the greatest prepayment risk and the highest yield. The PAC has the least.
7For numerical items, compute interest on the opening balance, then apply principal to the first outstanding tranche.
8Eliminate the two wrong options using the rule that a CMO conserves total risk.

Quickest way: Rank by protection

When to use it: Use this for conceptual MCQs that ask which tranche is safest, riskiest, or most affected by faster or slower prepayments.

Rank risk within a given structure: PAC tranche lowest prepayment risk, support tranche highest. Do not treat sequential tranches as a fixed middle category.
For sequential tranches, remember: first tranche = contraction risk; last tranche = extension risk.
Ask: does the option claim risk disappears? If so, reject it.
For floaters and inverse floaters, compare coupon direction with rate direction.

Common mistakes in Collateralized Mortgage Obligations (CMOs)

Saying a CMO eliminates prepayment risk.
Tranches with PAC protection look safe, so students assume the whole structure is safe.
Fix: Remember that the risk is redistributed. Whatever the PAC avoids, the support tranche bears.
Thinking the support tranche is protected.
The word 'support' sounds protective.
Fix: Support means it supports the PAC by absorbing prepayment variation. It has the most risk and the highest yield.
Thinking a PAC is protected at any prepayment speed.
Students forget the collar.
Fix: Protection holds only within the PAC collar and while support tranches remain outstanding.
Giving every sequential tranche the same risk.
All tranches draw from the same collateral.
Fix: Early tranches carry contraction risk. Later tranches carry extension risk.
Paying principal to several sequential tranches at once.
Confusing it with a pass-through, which pays pro rata.
Fix: In a basic sequential structure, only the first outstanding tranche gets principal. Interest goes to all.
Treating an inverse floater as lower risk because it is floating.
The word 'floater' suggests stable value.
Fix: An inverse floater's coupon falls when rates rise, so its price is very sensitive to rates and it is leveraged.

Worked examples

Example 1

A sequential-pay CMO has Tranche A ($60 million), Tranche B ($40 million) and Tranche C ($30 million). In month 1, scheduled and prepaid principal from the collateral is $2 million. Which statement is correct? A) Principal is shared pro rata among A, B and C. B) Tranche A receives all $2 million of principal. C) Tranche C receives all $2 million because it has the longest maturity.

Show the solution

In a sequential-pay structure, principal goes to the first outstanding tranche.
Tranche A has a balance of $60 million, so it is outstanding.
Therefore Tranche A receives the whole $2 million.
Option A describes a pass-through. Option C reverses the order.

Answer: B

Example 2

Interest rates fall and prepayments rise, but the speed stays inside the PAC collar. Which tranche is most likely to experience the greatest change in average life? A) Support tranche B) PAC tranche C) Both are affected equally

Show the solution

Speeds are inside the collar, so the PAC keeps following its planned schedule.
The support tranche absorbs the extra principal from the faster prepayments.
Because it takes that extra principal, the support tranche is paid down sooner and its average life shortens most.
If prepayments slowed instead, the support tranche would receive less principal and its average life would lengthen.
Option B is wrong because the PAC stays on schedule inside the collar. Option C ignores the priority structure.

Answer: A

Exam tips

Expect conceptual items: which tranche has the most contraction risk, extension risk, or the highest yield.
Never choose an option saying a CMO removes prepayment risk.
Keep the ends of the risk ladder in mind: PAC has the least prepayment risk, support the most. Do not place sequential tranches as a fixed middle category; their risk depends on position and structure.
For numerical items, compute interest from the opening balance, then direct principal to the first outstanding tranche.
With three options, discard the one that contradicts the order of principal payment first.

Practice questions from Fixed-Income Securitization

Collateralized Mortgage Obligations (CMOs) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

FRM Part ICollateralized Mortgage Obligations and Tranching

Collateralized Mortgage Obligations (CMOs): frequently asked questions

How does a CMO reduce prepayment risk?

It does not reduce the total risk. It divides the collateral cash flows into tranches so that some tranches get more predictable cash flows while others, such as support tranches, absorb the uncertainty.

What is the difference between a PAC and a support tranche?

A PAC has a planned principal schedule that holds within a prepayment collar. A support tranche takes the variation in principal payments, so it has more prepayment risk and a higher yield.

Which sequential tranche has contraction risk?

The earliest tranches have the most contraction risk, because fast prepayments retire them early. The last tranche has the most extension risk.

What is a Z (accrual) tranche?

A Z tranche receives no cash interest at first. Its interest is added to its principal balance, and that cash is used to pay down earlier tranches. It has high extension risk.