What is a Z-Tranche?

A Z-tranche is the last tranche of a bond that relies on payments from underlying securities.

How Does a Z-Tranche Work?

To understand how Z-tranches work, it's important to understand how they're created. Let's assume you want to buy a house, and so you get a mortgage from XYZ Bank. XYZ Bank transfers money into your account, and you agree to repay the money according to a set schedule. XYZ Bank (which could also be a thrift, credit union, or other originator) may then choose to hold the mortgage in its portfolio (i.e., simply collect the interest and principal payments over the next several years) or sell it.

If XYZ Bank sells the mortgage, it gets cash to make other loans. So let's assume XYZ Bank sells your mortgage to ABC Company, which could be a governmental, quasi-governmental or private entity. ABC Company groups your mortgage with similar mortgages it has already purchased (referred to as 'pooling' the mortgages). The mortgages in the pool have common characteristics (i.e., similar interest rates, maturities, etc.).
ABC Company then sells securities that represent an interest in the pool of mortgages, of which your mortgage is a small part (called securitizing the pool). It sells these Mortgage-backed Securities (MBS) to investors in the open market. When you make your monthly mortgage payment to XYZ Bank, XYZ Bank keeps a fee or spread and sends the rest of the payment to ABC Company. ABC Company in turn takes a fee and passes what's left of your principal and interest payment along to the investors who hold the MBS (ABC Company hires a central paying agent to accomplish this administratively).

Investors who buy the Z-tranche of the MBS start receiving interest and principal payments only after all the other tranches have been paid. These bonds can have maturities as long as 20 years or more. Interest accrues on these bonds, but no cash payments are made until the other tranches have been retired.

Why Does a Z-Tranche Matter?

Z-tranches are the riskiest tranche of an MBS because investors receive no cash payments for an extended period of time and thus may be more likely to be left holding the bag if the underlying mortgages default. However, the presence of Z-tranches also makes the more senior tranches more secure -- after all, those tranches (and their investors) get the Z-tranche's payments first. One advantage, however, is that the holder of a Z-tranche does not face much reinvestment risk—he or she will continue to accrue interest as the stated interest rate for the life of the bond (even though no cash payments may come immediately).

For investors, an MBS is much like a bond. Most offer semi-annual or monthly income, and this payment frequency enhances the compounding effects of reinvestment. However, it is important to note that payments that are part interest and part principal could be unfavorable to some investors, because with each decrease in outstanding principal there is a corresponding decrease in the amount of interest that accrues. For example, a $50,000 Ginnie Mae with a 5% coupon would pay $208.33 ($50,000 x .05/12) in interest every month, but it might also pay $100 in principal. This means that only $49,900 is earning interest next month, and by the end of the year there may only be $48,800 earning interest. The return of principal could also vary depending on how quickly the underlying mortgages are repaid.

Prepayment risk is a large concern for MBS investors. When people move, for example, they sell their houses, pay off their mortgages with the proceeds, and buy new houses with new mortgages. When interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate mortgages and pay off their higher-rate mortgages with the proceeds. Like bonds, changes in interest rates affect MBS prices, but the change is exacerbated by the fact that MBS investors are more likely to get their principal back early. They might have to reinvest that principal at rates below what their MBS were yielding.