Z-Bond Definition

What is the Z-Bond?

A Z bond, also known as a regularization obligation, is often the last link to mature. He receives the payment, which is the accumulation of interest added to the principal, after all other classes of bonds.

Key points to remember

  • A Z bond, also known as a regularization bond, is often the last bond to mature. He receives the payment, which is the accumulation of interest added to the principal, after all other classes of bonds.
  • A Z bond is a type of mortgage-backed security (MBS) and the final tranche of a secured mortgage bond (CMO).
  • Z-Bonds are classified as speculative investments and can be risky for investors.

Understanding Z-Bond

A Z-bond is the last slice of a secured mortgage bond (CMO). As the last part of the debt security, he receives the payment last. Unlike other tranches of a CMO, a Z bond does not distribute payments to its holder until all separate tranches have been paid. However, interest will continue to accrue for the duration of the mortgage. So, when the Z-bond finally pays off, its holder can expect a large sum. The bond will pay both principal and interest.

Z bonds are classified as speculative investments and can be risky for investors. A Z bond is a type of Mortgage security (MBS). An MBS is made up of a pool of underlying securities which are usually mortgages. An MBS is only secured by the lender’s confidence in the borrower’s ability to make their mortgage payments.

If a group of borrowers all default on their mortgage payments, and those mortgages are bundled into a single CMO, the investor holding a Z bond for that CMO may lose money. Without the incoming mortgage payments, the bonds cannot be repaid. People who have invested in other tranches of the CMO can still recover their initial investment. However, since Z-bonds pay out after all other portions, the holder of the Z-bonds stands to lose the most. Conversely, the inclusion of Z-bonds increases confidence in other CMO tranches, since Z-bond payments can be applied to meet payment obligations of other tranches before Z-bond obligations.

Minimize Z-Bond Risk

Most mortgage-backed securities are issued either by a federal agency or by a government sponsored entity (GSE) such as Fannie Mae and Freddie Mac. Those issued by a federal agency are backed by the full faith and credit of the US government. This way, they can be extremely low risk because they are backed by the US Treasury.

However, a government sponsored entity (GSE) does not have the backing of the US Treasury. These entities can borrow money directly from the Treasury, but the government is not obligated to provide funds to bail out these agencies if they find themselves unable to pay their debts. Although these securities carry some risk, this risk is generally considered to be low. For example, during the Financial crisis of 2007-08Freddie Mac and Fannie Mae were put on trial too big to failand the US Treasury stepped in to support their debt.

A smaller portion of mortgage-backed securities (MBS) comes from private companies, such as investment banks and other financial institutions. These securities should be considered much higher risk, as the US government does not support them. Issuers cannot borrow directly from the US Treasury in the event of mortgage defaults.