Introduction

A Companion Tranche, also known as a Support Tranche, is a component of a Collateralized Mortgage Obligation (CMO) that plays a critical role in absorbing payment volatility caused by changes in prepayment rates on the underlying mortgage assets. Its primary function is to shield the stability of more senior tranches, such as the Planned Amortization Class (PAC) and Targeted Amortization Class (TAC) tranches, which are designed to provide predictable cash flows.

In India, although CMOs are not as widely traded as in the U.S., the concepts of tranching and prepayment risk absorption are increasingly gaining attention, especially in structured finance products backed by real estate loans, NBFC portfolios, and securitised assets.

What Is a Companion Tranche?

A Companion Tranche is part of a CMO structure that helps maintain the predictability of payments to PAC and TAC tranches by absorbing any variations in the prepayment rate of the underlying mortgage pool. Prepayments—when borrowers pay off their mortgages earlier than scheduled—can disrupt the expected cash flow structure. The companion tranche takes on this volatility.

Key Characteristics:

• Absorbs prepayment risk in the CMO structure.
• Offers variable cash flows, unlike the fixed flows of PAC/TAC tranches.
• Carries higher risk and potentially higher yield.
• Ensures stability of principal and interest payments to senior tranches.

Why Is the Companion Tranche Important?

In any mortgage-backed security, cash flow depends on when and how the borrowers repay their loans. Early or delayed prepayments can disrupt the repayment plan across tranches. The companion tranche acts as a buffer, absorbing this inconsistency.

Example Scenario:

• If prepayments increase, the companion tranche gets paid earlier.
• If prepayments decrease, the companion tranche is paid later.
• In both cases, the PAC and TAC tranches continue receiving stable, scheduled payments.

Who Invests in Companion Tranches?

• High-risk investors looking for higher yields.
• Institutional players, such as hedge funds or structured credit funds.
• Investors who are well-versed in interest rate cycles and prepayment trends.
• Not suitable for risk-averse or conservative investors, as payment schedules can be unpredictable and are highly sensitive to mortgage prepayment rates.

Relevance in the Indian Context

While CMOs in the U.S. are well established, India's securitisation market is still evolving. However, similar tranche structures are seen in pass-through certificates (PTCs) and other mortgage-backed securities issued by NBFCs and housing finance companies.

In Indian mortgage-backed deals, companion-like tranches are used to enhance credit quality and stabilise returns to senior tranches, ensuring compliance with investor expectations and rating agency benchmarks.

Risks Associated with Companion Tranches

• Prepayment Volatility: High sensitivity to early repayments or defaults.
• Extension Risk: If prepayments slow, returns are delayed.
• Market Risk: Changes in interest rates impact prepayment behaviour, affecting cash flows.

These risks are balanced by the potential for higher returns, making companion tranches suitable only for investors with strong risk appetite and market insight.

Conclusion

The Companion Tranche is a crucial part of any Collateralized Mortgage Obligation (CMO), designed to absorb the unpredictability of mortgage prepayments and ensure payment stability to senior tranches like PAC and TAC. It plays the role of a shock absorber, enabling structured finance instruments to deliver the predictability demanded by conservative investors.

In India’s gradually maturing securitisation market, the role of companion tranches or their equivalents is expanding, especially in deals backed by housing loans, SME finance, and NBFC portfolios. Understanding how these tranches work is essential for investors, structurers, and regulators who deal with complex debt products.

References used: 

• https://www.investopedia.com/terms/c/companion-tranche.asp
• https://en.wikipedia.org/wiki/Collateralized_mortgage_obligation

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