Tac

Key Takeaways

• Targeted amortization class (TAC) is an asset-backed security designed to mitigate prepayment risk for investors by following a fixed principal payment schedule.
• TAC tranches offer steady cash flow by using a single prepayment speed assumption (PSA), differing from planned amortization class (PAC) tranches that use a range.
• TACs are often associated with collateralized mortgage obligations (CMOs) and mortgage-backed securities (MBS), providing predictable cash flow.
• Unlike PACs, TACs are more susceptible to prepayment risk above or below the set PSA, making them riskier but potentially higher yielding.
• PAC tranches are senior to TAC tranches, offering less yield but more security, impacting the risk profile of TAC tranches.

What Is Targeted Amortization Class?

Targeted amortization class (TAC) is a type of asset-backed security that provides protection against prepayment risk. TAC tranches are specifically structured to offer investors steady cash flow and a fixed principal payment schedule by using a predefined principal balance schedule and a single prepayment speed assumption.

A TAC tranche is similar to a planned amortization class (PAC) tranche in that it protects investors from prepayment. However, targeted amortization class tranches are structured differently than PAC tranches in that they only use one PSA rather than a range, as PAC tranches do.

We'll explain how TAC tranches are structured, their benefits, and their relationship with PAC tranches.

How Targeted Amortization Class (TAC) Works

Targeted amortization class tranches are structured products that increase cash flow certainty. TAC tranches can be created with any asset-backed security with a payment schedule, but they are most strongly associated with collateralized mortgage obligations (CMO) and mortgage-backed securities (MBS). The targeted amortization class tranche is essentially a bond under a CMO or MBS. For the TAC tranches, the principal is paid on a predetermined schedule. Any prepayment that occurs is amortized in order to maintain the schedule, stretching the cash flow predictably rather than returning capital in what is likely to be a lower interest environment than when the product was created.

Comparing Targeted Amortization Class (TAC) and Planned Amortization Class (PAC)

As mentioned, a planned amortization class tranche uses a range of prepayment rates, whereas a targeted amortization class tranche uses one. For a PAC, changes in the prepayment rates—either a rise in prepayment or burnout—are baked into the model to some extent. Unlike a PAC holder, a TAC investor will see more or less principal than is scheduled depending upon whether the prepayment rate is higher or lower than the defined rate.

For example, if prepayment rates are below the rate used for the TAC, the principal amounts will not be available for scheduled payment, so the life of the TAC will need to be extended. Alternately, the prepayment protection is also limited if the prepayment rate exceeds the PSA used for the TAC. Investors will see their investment returned in what is bound to be a worse interest rate environment.

In fact, the existence of PAC tranches negatively impacts TAC tranches. The PAC tranches are senior to TAC tranches. So, in the hierarchy, PAC tranches yield less and have the lowest risk, TAC tranches yield more than PACs but carry limited protection, and other tranches yield more but carry no protection against prepayment.

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