Transcript Document

Understanding
Callable Securities
PFM Asset Management
Nancy Jones and Nsesa Kazadi
50 California Street, Suite 2300 San Francisco, CA 94111
415-982-5544 www.pfm.com
Callable Federal Agencies
• Federal Agency security with a call option
• Call option allows the issuer to redeem the security prior to maturity, at
the call date
– One time
– Continuously
– Periodically
• Issuers pay a premium in the form of a higher yield for this feature
Yield on Bullet Security
+ Call Option Premium
Yield on Callable Security
• The option premium is based on:
– Current interest rates
– Expected future rates
– Call structure
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
Callable or Non-Callable
Principal $1,026,250
is
returned early if
security is called
2 year, non-call one,
5.25% Coupon
$1,000,000 par
$1,026,250
$26,250
$26,250
Year 1
Year 2
-$1 million
Principal
Presenters: Nancy Jones and Nsesa Kazadi
Interest
PFM Asset Management
Callable Federal Agency Securities
Pros
Cons
High credit quality
Date principal is returned
is uncertain
Additional yield advantage
More challenging to
analyze competitive offers
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
Maturity Distribution: Call vs. Maturity Date
$140
To Maturity
To Next Call
$120
millions
$100
$80
$60
$40
$20
$0
0-1 Year
1-2 Years
Presenters: Nancy Jones and Nsesa Kazadi
2-3 Years
3-4 Years
4-5 Years
PFM Asset Management
Risk of Callable Securities
3-Year U.S. Treasury Note
January 1, 2000 – February 17, 2006
8.00%
Purchase of 3-year callable,
1-year non-call protection
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Jan00
Jul00
Jan01
Jul01
Jan02
Jul02
Jan03
Jul03
Jan04
Jul04
Jan05
Jul05
Jan06
Source: Bloomberg
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
Current Rates
3-Year Federal Agency
Yield
Bullet (Non-Callable)
4.88%
Non-Call 1-Year; 1-Time Call
5.075%
Non-Call 3-Months; Quarterly Call
5.375%
Rates as of February 9, 2006
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
Select the Best Offer
Which security would you buy?
Option 1
Option 2
New Issue
Secondary Market
FHLMC 5.125%
FNMA 5.10%
February 27, 2008
February 22, 2008
2/27/07 (1-time)
2/22/07 (1-time)
February 27, 2006
February 22, 2006
Price
100.00
99.94
Yield to Call
5.125%
5.162%
Yield to Maturity
5.125%
5.132%
Type of Issue
Description
Maturity Date
Call Date
Settles
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
Advantages
Type of
Issue
Description
Advantages
Option 1
Option 2
New Issue
Secondary Market
FHLMC 5.125%
FNMA 5.10%
Longer time to
call date
Presenters: Nancy Jones and Nsesa Kazadi
Higher yield-to-call
Higher yield-to-maturity
Shorter settlement date
(earn yield sooner)
PFM Asset Management
Still Undecided? “OAS” it!
• Option Adjusted Spread Analysis (OAS) can help you
select the cheapest callable security.
• OAS models calculate the value of the call option to
arrive at an “option-free” yield spread.
• The OAS provides an apples-to-apples comparison of
callable securities with similar structures.
• You can also compare the OAS to yield spreads of
similar non-callable securities.
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
Option Adjusted Analysis
FHLMC 5.125%
February 27, 2008 O.A.S.
Effective Duration
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
Option Adjusted Analysis
FNMA 5.10%
February 22, 2008 O.A.S.
Effective Duration
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management
More Yield = Better Returns?
Not Always
• When buying callable securities, more yield does not
always equal more income or better returns!
• Reinvestment risk: securities get called when rates
fall, thus reducing income
• Negative convexity: price appreciation is limited
while potential price decline is unlimited
Presenters: Nancy Jones and Nsesa Kazadi
PFM Asset Management