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What is a Z-Bond?
Let me explain what a Z-bond is directly to you: it's also known as an accrual bond, and it's typically the last bond to mature in its structure. You receive payment on it—which includes the accrual of interest added to the principal—only after all other bond classes have been paid off.
Key Takeaways
- A Z-bond, also known as an accrual bond, is often the last bond to mature and receives payment, which is the accrual of interest added to the principal, after all other bond classes.
- A Z-bond is a type of mortgage-backed security (MBS) and the last tranche of a collateralized mortgage obligation (CMO).
- Z-Bonds are categorized as speculative investments and can be risky for investors.
Understanding Z-Bonds
You need to understand that a Z-bond is the last tranche of a collateralized mortgage obligation (CMO). As the final portion of this debt security, it gets paid last. Unlike the other tranches in a CMO, a Z-bond doesn't distribute payments to you until all the separate tranches are fully paid. However, interest keeps accruing throughout the life of the mortgage, so when the Z-bond finally pays off, you can expect a substantial amount that includes both principal and interest.
I want to be clear: Z-bonds are speculative investments and carry risks for you as an investor. They are a form of mortgage-backed security (MBS), which consists of a pool of underlying securities, usually home mortgages. An MBS is secured solely by the lender's trust in the borrower's ability to make mortgage payments.
If a group of borrowers defaults on their mortgages, and those are bundled into a single CMO, you as the Z-bond holder could lose money. Without incoming mortgage payments, the bonds can't be repaid. Investors in other tranches might recover their initial investment, but since Z-bonds pay out after everything else, you stand to lose the most. On the flip side, including Z-bonds boosts confidence in the other CMO tranches, as their payments can be used to meet the obligations of those tranches before addressing the Z-bond.
Minimizing Z-Bond Risk
Most mortgage-backed securities are issued by federal agencies or government-sponsored entities (GSEs) like Fannie Mae and Freddie Mac. If issued by a federal agency, they're backed by the full faith and credit of the U.S. government, making them extremely low risk because the U.S. Treasury guarantees them.
However, GSEs don't have direct U.S. Treasury backing. They can borrow from the Treasury, but the government isn't required to bail them out if they can't pay their debts. Still, the risk is generally low—for instance, during the 2007-08 Financial Crisis, Freddie Mac and Fannie Mae were considered too big to fail, and the Treasury supported their debt.
A smaller share of MBS comes from private firms, such as investment banks and other financial institutions. You should view these as significantly higher risk, since they're not backed by the U.S. government, and the issuers can't borrow directly from the Treasury if mortgages default.
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