Definition of Z-bond
It is the final tranche in a series of mortgage-backed securities that is the last one to receive payment. Z-bonds are used in some collateralized mortgage obligations. It does not pay coupon payments while the principal is being paid on earlier bonds.
Interest payable on a Z-bond is added to the principal balance and becomes payable once claims on all prior bond classes have been satisfied. A Z-bond is similar to a zero-coupon bond, since it accrues interest rather than paying it out. Therefore, the final tranche is considered the most risky for the CMO (Collateralized Mortgage Obligation) class structures.
Explanation of Z-bond
A Z-bond is the lowest tranche in a collateralized mortgage obligation (CMO). These bonds are not entitled to any coupon payments. Instead, the interest that would be paid on a Z-bond is used to pay off the principal on higher tranches in the CMO.
Z-bonds are only paying the principal and interest owed once the other tranches have been paid off. This makes Z-bonds the most volatile level of tranches as their market values can fluctuate greatly. Z-bonds have average life spans of 18 to 22 years. They provide stability in cash flows for the other tranches.