Identification
CMOs are bonds backed by pools of mortgages. Investors profit from the principal and interest payments made by homeowners into the CMO. The pool is divided into portions called tranches, with varying terms. Investors purchase tranches according to their risk profiles.
Features
CMOs often categorize themselves into principal and interest-only bonds for investors. Principal-only bonds are bought at a discount and do not pay interest. For example, one principal-only bond may be bought for $800---with a $1,000 face value. The $1,000 loan is repaid one year later for a $200 profit.
Benefits
Investors purchase CMOs to diversify housing market risks. Rather than investing in one mortgage, the investor spreads the default risk across thousands of homeowners.
Effects Of Prepayment
Mortgage prepayment adversely affects CMO performance. Homeowners refinance into lower interest rates and use new mortgages to pay off old loans. CMO investors then lose out on future interest payments and are forced to reinvest money within the lower interest rate environment.
Risks
CMOs are difficult to research because of their complexity and the disconnection between investors and homeowners.
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