Sequential Pay Structure
Definition
A principal distribution method in CMOs and structured credit where principal payments (scheduled amortization plus prepayments) are directed entirely to the first tranche until fully retired, then to the second tranche, and so on. This creates maturity tranches—Class A may mature in 2-4 years, Class B in 5-8 years, Class C in 9-12 years—from a single collateral pool with average life of 6-8 years.
Why it matters
Sequential pay structures solve the average life problem in MBS. A 30-year mortgage pool has 8-12 year average life, but investors want specific maturities (short for ALM, long for duration). Sequential pay creates multiple maturity points from one pool. This explains CMO complexity—seemingly simple MBS gets tranched into 10-15 classes with different prepayment exposures, durations, and yields. Understanding sequential mechanics is essential for evaluating which tranches get hit hardest by prepayments (early tranches) vs. extension risk (late tranches).
Technical details
Principal allocation mechanics
In sequential structure, all principal (scheduled + unscheduled) flows to Class A until fully paid. Example: $300M pool with Classes A ($100M), B ($100M), C ($100M). Month 1: $5M total principal. All $5M goes to Class A. Class A now $95M outstanding. Month 20: Class A fully paid. All principal now flows to Class B. Month 50: Class B fully paid. All principal flows to Class C. Interest payments are pro-rata to all outstanding classes based on remaining balances. This sequential principal creates maturity tranches: Class A paid off in ~2 years, B in ~5 years, C in ~10 years, from same underlying 30-year mortgages.
Average life distribution across tranches
Sequential pay redistributes average life risk. Underlying pool: 8-year average life at 100 PSA. Class A (early tranche): 2-3 year average life. Gets principal first, faces compression risk if prepayments speed up (average life shortens). Class B (middle): 5-7 year average life. More stable, less prepayment sensitivity. Class C (late/Z-bond): 12-15 year average life. Faces extension risk if prepayments slow (average life extends). This creates different investor bases: Class A for money market funds/short ALM. Class B for balanced accounts. Class C for insurance/pension long duration.