Companion bonds are sometimes known as support or companion tranches. The companion bond serves the function of assimilating any excess in the principal payments when a period of high prepayment speed is taking place. At the same time, companion bonds will function as a means of deferring the reception of principal payments when a period of low prepayment speeds occurs. In both situations, companions bonds help to reduce the amount of prepayment risk involved with the bond.
One of the most common applications of companion bonds is found within the planned amortization class of bonds. Essentially, the bonds function with the PAC bond environment by taking as much of any excess PAC tranche prepayments and using the excess to make additional payments on the principal amount of the bond. Once the principal is paid in full, any excess payments are then applied to the PAC bond.
A similar approach takes place with a CMO tranche, in that the process of companion bonds helps to regulate the payment on the principal based on the current type of prepayment activity. The goal is to ensure that both the principle bond and the attending CMO bond is covered in full in a timely manner.
The function of companion bonds depends a great deal on the way that the prepayment process proceeds. As long as the speed of the prepayments remains within specified upper or lower levels of the PAC collar involved, the bonds will work in the manner intended. However, if other factors enter the picture that make it impossible to keep the speed of the prepayments in either of these extremes, the ability of companion bonds to work in conjunction with the main bond is hampered. Fortunately, circumstances of this type rarely occur.
Brokers who are used to working with bond issues can explain to an investor the relationship between planned amortization class bonds and companion bonds, and why the process works so well. While companion bonds are not automatically part of the structure for all bond issues, the application of companion bonds to the process is not uncommon. Any investor who wishes to acquire bonds should become well acquainted with the process of companion bonds.