What does Companion Tranche mean?
A companion tranche is called so because it "accompanies" a collateralized mortgage obligation (CMO) that has a Planned Ammortization Class (PAC) or Target Amortization Class (TAC) tranche. Companion tranche is a type of tranche that absorbs the volatility in prepayment pattern due to interest change that may arise due to fluctuations in the payback of mortgages.
It is also known as Support Tranche.
Futures Knowledge Explains Companion Tranche
For example, if interest rate falls, the homeowner rush to lenders to prepay costly mortgage. This affects the investors, known as contraction risk. The companion tranche protects them from contraction risk by absorbing the excess principal payments during a cut in Interest rates. The objective of a companion tranche is to even-out any variability in prepayment patterns. The difference between the actual rate of pre-payment and the planned is adjusted by companion tranche. This ensures steady cash flows to investors, plus the companion tranche carries a higher return.