Companion tranche

Companion tranche

Within the complex world of finance, with plenty of investment alternatives, the companion tranche is one unique and subtle part of the mortgage-backed securities market. With its distinct risk-return profile, this specialised tranche deepens and complicates the world of structured finance. By exploring the complexities of companion tranches, we uncover a financial tool that straddles the line between risk management and innovation, providing an intriguing look at the workings of contemporary financial markets. 

What is a companion tranche? 

A companion tranche is a type of tranche in a collateralised mortgage obligation (CMO) that has a specified relationship with another tranche, known as the “support” tranche. Interest and principal payments are only made to the companion tranche upon the retirement of the support tranche.  

As losses from mortgage defaults or prepayments predominantly impact the support tranche, this arrangement offers some protection to investors in the companion tranche. Also, as payment distributions in companion tranches are sequential, investors usually aim for larger yields at the expense of more risk. The mortgage-backed securities complex offers customised risk exposure and return possibilities thanks to its tranche structure. 

Understanding companion tranche 

A unique part of a collateralised mortgage obligation (CMO) that adds a layer of return and risk to the overall structure is called a companion tranche. The companion tranche is designed to receive interest and principal payments following the satisfaction of other tranches within the CMO, positioning it to absorb prepayment and extension risk. Its profitability is closely linked to the underlying mortgage pool’s prepayment patterns. Due to the uncertainty surrounding borrower prepayment rates, investors in companion tranches may encounter greater cash flow unpredictability than in other tranches.  

Companion tranches, which are known for their higher yields, are preferred by investors who are prepared to assume more risk in exchange for the possibility of more significant returns. As such, they are a wise choice for individuals who have a sophisticated understanding of mortgage-backed securities and a risk tolerance. 

Working of a companion tranche 

A companion tranche is designed to withstand fluctuations in interest rates. It is the first tranche to experience prepayment losses and the last to receive principal payments. Prepayments decrease when interest rates climb, extending the average life of the companion tranche and shielding it from early payoffs.  

During dropping interest rates, prepayments quicken, shortening the tranche’s average life. While delivering potentially greater yields, companion tranches are riskier due to their susceptibility to interest rate swings, making them ideal for educated investors with a strong understanding of the intricate dynamics underlying mortgage-backed securities. 

Role of companion tranche 

Companion tranches, which are frequently included in collateralised mortgage obligations (CMOs), are essential for investors’ risk and return structuring. Companion tranches are designed to insulate against fluctuating prepayment rates. They are positioned in between the scheduled and support amortisation classes. They take on greater risk during periods of heavy prepayments, shielding other tranches. When prepayments are slower, investors are less exposed and can earn higher interest rates.  

Companion tranches are an excellent option for investors looking to balance risk and return in the complicated world of mortgage-backed securities because of their dynamic risk-sharing feature, which also gives them some flexibility and adaptability to shifting market conditions. 

Example of Companion Tranche 

An Interest-Only (IO) tranche is a typical example of a companion tranche. An IO tranche of a mortgage-backed asset only gets interest payments from the mortgage loans that underpin it, offering investors the chance to earn greater returns. But other tranches, such as the principal-only (PO) tranche, are the recipients of the principal payments. As a result, the IO tranche complements the PO tranche by providing a distinct risk-return profile inside the same MBS structure. 

Frequently Asked Questions

Whether a companion tranche is right depends on your investing goals and risk tolerance. As companion tranches are more vulnerable to fluctuations in interest rates, they carry a higher risk and a more significant potential return. A financial advisor can determine if this sophisticated mortgage-backed product fits your investing philosophy and risk tolerance. 

Risk-tolerant investors are drawn to equity tranches because they present more enormous profits at a higher risk. They serve as a safety net for senior tranches by taking on losses first. For investors looking for more consistent returns, companion tranches offer steady cash flow at a lower risk. When combined, they let investors customise their risk-return profiles. 

A collateralized mortgage obligation (CMO) consists of companion tranches and equity tranches. Equity tranches are the riskiest since they have a bigger potential return but absorb losses first. On the other hand, companion tranches are designed to absorb excessive interest and provide a safety net for the principal repayment plan. They are safer than equity tranches and provide a more consistent dividend source. Together, the two tranches provide a diverse investment package; companion tranches offer a more stable income flow, while equity tranches assume higher risk to earn more significant returns. 

Before purchasing companion tranches or equity in mortgage-backed securities, consider variables like prepayment risk, economic conditions, and changes in interest rates. Understanding the possible risks and returns connected to these intricate financial instruments requires evaluating the credit quality of the underlying mortgages, the structure of the tranches, and the general state of the market. 

Collateralised Mortgage Obligations consist of companion tranches and equity tranches (CMOs). Since equity tranches are the last to receive cash flows, successful investments carry a higher risk and potentially higher reward. Companion tranches are designed to insulate against prepayment risk and give a modest risk and return. Until the other tranches are paid in full, these tranches only get interest payments. Thus, a thorough awareness of risk tolerance, market dynamics, and the particulars of the underlying assets is necessary for successful investing in these tranches

Related Terms

    Read the Latest Market Journal

    Recognising Biases in Investing and Tips to Avoid Them

    Published on Sep 4, 2025 35 

    Common biases like overconfidence, herd mentality, and loss aversion influence both risk assessment and decision-making....

    What is Money Dysmorphia and How to Overcome it?

    Published on Sep 4, 2025 15 

    Money dysmorphia happens when the way you feel about your finances doesn’t match the reality...

    The Employer’s Guide to Domestic Helper Insurance

    Published on Sep 2, 2025 63 

    Domestic Helper insurance may appear to be just another compliance task for employers in Singapore,...

    One Stock, Many Prices: Understanding US Markets

    Published on Aug 26, 2025 259 

    Why Isn’t My Order Filled at the Price I See? Have you ever set a...

    Why Every Investor Should Understand Put Selling

    Published on Aug 26, 2025 107 

    Introduction Options trading can seem complicated at first, but it offers investors flexible strategies to...

    Mastering Stop-Loss Placement: A Guide to Profitability in Forex Trading

    Published on Aug 19, 2025 128 

    Effective stop-loss placement is a cornerstone of prudent risk management in forex trading. It’s not...

    Boosting ETF Portfolio Efficiency: Reducing Tax Leakage Through Smarter ETF Selection

    Published on Aug 15, 2025 160 

    Introduction: Why Tax Efficiency Matters in Global ETF Investing Diversification is the foundation of a...

    How to Build a Diversified Global ETF Portfolio

    Published on Aug 15, 2025 106 

    Introduction: Why Diversification Is Essential in 2025 In our June edition article (https://www.poems.com.sg/market-journal/the-complete-etf-playbook-for-singapore-investors-from-beginner-to-advanced-strategies/), we introduced...

    Contact us to Open an Account

    Need Assistance? Share your Details and we’ll get back to you

    IMPORTANT INFORMATION

    This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.  

    An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.  

    Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.  

    Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.  

    The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <www.phillipfunds.com> for more information in relation to the dividend distributions.  

    The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.  

    The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published. 

    This advertisement has not been reviewed by the Monetary Authority of Singapore.  

     

    Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)  
    250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101 
    Tel: (65) 6230 8133 Fax: (65) 65383066 www.phillipfunds.com