A Z-bond is a type of bond sometimes used in a collateralized mortgage obligation (CMO). This is a financial arrangement by which investors receive a share of the income produced by multiple mortgage loans. The Z-bond is one of a series of bonds in such an arrangement and stands out because it does not pay any interest until the end of the lifespan of the CMO.
A collateralized mortgage obligation is technically an self-contained entity in the same way a corporation is. The CMO buys up the rights to receive income from mortgage repayments, usually by paying the original lenders a high proportion of the total mortgage amounts. The money used to buy up these rights comes from the CMO issuing bonds to investors, paying them back with the mortgage income.
With most CMOs, there are several different types of bonds available for investors. There will be a specific order of priority for payments to the different types of bonds, meaning that if some of the mortgage holders default, it is possible some bondholders will miss out on interest payments or even not get back their original investment when the bond comes due for redemption. In most cases, the lower the priority for a particular bond, the higher the interest rate it pays — or at least is scheduled to pay. Having different types of bond allows investors to pick a specific balance of risk and reward.
A Z-bond differs from other types of bonds in a CMO in that it does not pay interest to bondholders during the bond's lifespan. Instead the money that would have paid such interest is used to help fund the interest payments on other types of bond. When the Z-bond does finally come due for redemption, the holder gets back his original investment plus a one-off payment covering all the interest the bond has earned, or accrued, during its lifespan.
While this does not have to be the case, Z-bonds will often be set with longer running periods than other bonds in the CMO. This would mean that in the year the Z-bond comes due for redemption, the CMO has no other bonds or interest to pay. Thus, the money received in mortgage income that year can be dedicated entirely to repaying Z-bonds and associated interest.
It is possible to have multiple classes of Z-bond in the CMO. This usually involves the different classes having different running times so that they do not come due for redemption in the same year. It is even technically possible to have a CMO that only uses Z-bonds.