Transcript No Slide Title

Fixed Income 3
Zvi Wiener
02-588-3049
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
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Fixed Income
Government-Sponsored Enterprises
Fannie Mae “benchmark” and Freddie Mac
“reference” notes and bond.
Can be electronically transferred through
clearing houses as Euroclear and Cedel and
NBES.
Outstanding amount $150B with 2-30 years to
maturity.
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Government-Sponsored Enterprises
GNMA - Government National Mortgage
Association
FHLBS - Federal Home Loan Bank System
Sallie Mar - Student Loan Marketing
Association
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Corporate Debt Instruments
• corporate bonds
• medium-term notes
• CP = commercial papers
• ABS = asset backed securities
They have priority over common stocks in the
case of bankruptcy.
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Corporate Bonds
Main types of issuers
• utilities
• transportation
• industrial
• banks and financial companies
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Bond Indentures
• trustee
• term bonds, serial bonds
• collateral
• debenture bond - not secured
• guaranteed bonds
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Bond Provisions
• Call and refund provisions - the issuer has
the right to redeem the entire amount before
maturity. Sometimes there is a premium to be
paid in such a case (redemption schedule).
• Special redemption prices for debt redeemed
through the sinking fund
• Refunding means replacing by another debt.
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Bond Provisions
• Sinking fund provision sometimes the issuer
is required to retire a portion of an issue each
year.
– either by cash payment to bondholders (lottery)
– or by buyback bonds
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Bond Rating
• Duff and Phelps Credit Rating Co.
• Fitch Investors Service
• Moody’s Investors Service
• Standard & Poor’s Corporation
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Rating
Moody’s
S&P
Fitch
D&P
Aaa
AAA
AAA
AAA
Aa1
AA+
AA+
AA+
Aa2
AA
AA
AA
Aa3
AA-
AA-
AA-
A1
A+
A+
A+
A2
A
A
A
A3
A-
A-
A-
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Rating
• BBB- or better = investment grade
• BB+ and below - speculative grade
• D to DDD default
• transition matrix
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One year transition matrix
Aaa Aa
A
Baa Ba
B
C&D
0
0
Aa
1.1 91.3 7.1 0.3 0.2 0
0
A
0.1 2.6 91.2 5.3 0.6 0.2 0
Aaa 91.9 7.38 0.72 0
Baa 0
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0
0.2 5.4 87.9 5.5 0.8 0.2
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High Yield Bonds
• LBO, downgrading, refinancing
• fallen angels
• deferred interest bonds
• Step-up bonds pay initially low interest
which increases with time
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SEC rule 144A
Allows to trade private placements among
qualified institutions.
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Medium Term Notes (MTN)
Notes are registered with the SEC under Rule
415 (the shelf registration) and are offered
continuously to investors by an agent of the
issuer.
Maturities vary from 9 months to 30 years.
Can be either fixed or floating.
Very flexible way to raise debt!
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Primary Market (MTN)
Issuer posts spreads over Treasuries for a
variety of maturities.
Then an agent tries to find an investor.
Minimal size is between $1M and $25M.
The schedule can be changes at any time!
Often structured MTNs are used (caps, floors,
etc.) = structured notes.
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Structured Notes
Many institutional investors can use swaps
and structured notes to participate in markets
that were prohibited.
Another use of structured notes is in risk
management.
Financial Engineering is used to create
securities satisfying the needs of investors.
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Commercial Papers
• Short term unsecured promissory note
• An alternative to short term bank borrowing
• A typical round-lot transaction is $100,000
• In the USA maturity is up to 270 days
• Requires less paperwork
• Those with maturity up to 90 days can be
used as collateral for FED discount window.
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Commercial Papers
• Typically rolled over
• Rollover risk is backed by an unused bank
credit line
• In order to issue CP one need either a high
rating or good collateral
• Sometimes credit enhancement is used (LOC)
• CP issued in the USA by foreigners are called
Yankee CP
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Commercial Papers
• Between 71 an 89 there was one default on CP.
• 3 defaults occurred in 89 and 4 in 90
• Direct paper is sold without an agent
• Secondary market is thin
• There is a special rating for CP, P-1,3, A-1,3
• discount instruments, used by money market
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Bankruptcy and Credit Rights
• liquidation - all assets will be distributed
• reorganization - a new corporate entity will
result
• a company that files for protection becomes
a debtor in possession and continues to
operate under the supervision of the court
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Bankruptcy and Credit Rights
Absolute priority rule - senior creditors are
paid in full before junior creditors are paid
anything.
Works in liquidation but often does not work
in reorganization.
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Municipal Securities
Exemption of interest income from federal
taxation.
Issued by states, counties, special districts, cities,
towns, school districts.
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Municipal Securities
Exemption of interest income from federal
taxation.
General obligation bonds - backed by tax power
Limited tax general obligation bonds
Revenue bonds - based on specific projects
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Municipal Securities
Airport Revenue Bonds
College and University Revenue Bonds
Hospital Revenue Bonds
Industrial Revenue Bonds
Single-Family Revenue Bonds (mortgages)
Multifamily Revenue Bonds (housing projects)
Water Revenue Bonds
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Hybrid and Special Bond Securities
• Insured bonds - typically by an insurance firm
• Bank-backed municipal bonds (letter of credit)
• Refunded Bonds - a portfolio of safe securities is
placed in trust and they will cover the payments.
• Troubled city bailout bonds
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Municipal Money Market Products
• TAN = tax anticipation notes
• RAN = revenue anticipation notes
• GAN = grant anticipation notes
• BAN = bond anticipation notes
• Tax exempt commercial paper
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Municipal Derivatives
• floaters = floating rate + spread
• inverse floaters = interest - floating rate
• strips
• partial strip = are zeros till a call date and
then become coupon type
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Yield on Municipal Bonds
tax-exempt yield
equivalent taxable yield =
1-marginal tax rate
for example bond offers 6.5% and marginal tax
rate 40%:
0.065
= 0.1083
1-0.40
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Non-US Bonds
• national bond markets
– domestic market
– Foreign market
Yankee
USA

Samurai Japan

bulldog UK

Rembrandt Holland

matador Spain
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International bond market
• Eurobond and Euroyen markets
• Global bond - simultaneous offering
• Typically registered in Luxembourg, London
or Zurich, but traded OTC.
• Supranationals - IBRD, World Bank, etc.
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Eurobond market
• Dual currency bonds (coupon in one
currency, principal in another).
• Option currency bond one side can choose
the currency.
• Convertible bonds with warrants - can be
converted into another asset. Equity, debt,
gold or currency warrant.
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Eurobond market
• Floating Rate Notes = FRN based on
LIBOR or LIBID
• many are collared
• some are perpetual
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Comparing Yields
bond equivalent yield of Eurodollar bond
=
2[(1+yield to maturity)0.5-1]
for example: A Eurodollar bond with 10%
yield has the bond equivalent yield of
2[1.100.5-1] = 9.762%
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Japanese Government Bonds JGB
• short term Treasury bills
• medium term bonds
• long term bonds
• super long term bonds (20 years)
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German Government Bonds
• U-Schatze discount paper up to 2 years
• Kassens = federal government notes (2-6 y.)
• OBLEs = 5 year federal government notes
• Bunds = federal government bonds (6-30 y.)
all coupon payments are annual
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UK Government Bonds Gilts
• straights = bullet bonds (some callable)
• convertibles (option to holder to convert to
longer gilts)
• index linked low coupon 2-2.5%
• irredeemable (perpetual)
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Brady Bonds
Argentina, Brazil, Costa Rica, Dominican
Republic, Ecuador, Mexico, Uruguay,
Venezuela, Bulgaria, Jordan, Nigeria,
Philippines, Poland.
Partially collateralized by US government
securities
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Internet sites
• www.federalreserve.gov/releases
• www.tradeweb.com
• www.bondclick.com
• www.fxall.com
• www.atriax.com
• www.convertbond.com
• www.bondsonline.com
• www.bba.org.uk
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Fixed Income 3
• Mortgage loans
• Pass-through securities
• Prepayments
• Agencies
• MBS
• CMO
• ABS
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Mortgage Loans
Mortgage is a loan secured by a specified real
estate property.
Conventional mortgage - credit of the
borrower and collateral.
Mortgage insurance - FHA, VA, FmHA
guaranteed by US government, there are
some private insurers as well.
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Mortgage Market
Mortgage originator - thrifts, banks
origination fee (in points = %)
PTI = payment to income ratio (include tax)
LTV = loan to value ratio
later on mortgages are securitized.
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Mortgage Services
Collecting payments, maintaining records
Servicing fee - % of outstanding plus some
other benefits.
Mortgage insurer required when LTV>80%.
Credit life - voluntary life insurance.
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Fixed Rate Mortgage
A series of equal payments with PV=loan.
Example: 100,000 for 20 years with 6% and
equal monthly payments.
100,000 
12*20

i 1
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x
 0.06 
1 

12 

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Adjustable-Rate Mortgage (ARM)
The contract rate is reset periodically, based
on a short term interest rate.
Adjustment from one month to several years.
Spread is fixed some time caps or floors.
Market based rates.
Rates based on cost of funds for thrifts.
Initially low rate is often offered = teaser rate.
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Balloon Mortgage
One payment at the end.
Sometimes they have renegotiation points.
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Two-Step Mortgages
A loan carries a fixed rate for some period
(usually 7 years) and then reset rates.
For example: 250 basis points plus average of
10-years Treasuries.
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Risk in Mortgages
Default risk
Liquidity risk
Interest rate risk
Prepayment risk
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Risk in Mortgages
Default risk is highly affected by LTV.
LTV>80% in 40% of loans
LTV>90% in 15% of loans
different state laws give different
rights to lenders.
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Prepayment Risk in Mortgages
Sale of home
Better interest rates
Irrational factors
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Mortgage Pass-Through Securities
A group of mortgages form a pool which is
securitized.
Payments are pooled, service fee deducted
and the rest divided.
WAC = weighted average coupon rate
WAM = weighted average maturity
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Mortgage Pass-Through Securities
Ginnie Mae = Government National Mortgage
Association, MBS or GNMA.
Freddie Mac = Federal Home Loan Mortgage
Corporation, PC = participation certificate.
Fannie Mae = Federal National Mortgage
Association, MBS.
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Role of Agencies
guarantee timely payments
1. Coupon only
2. Both coupon and principal
Ginnie Mae is guaranteed by the US
government. Securities guaranteed by Ginnie
Mae are called MBS = Mortgage Backed
Securitiy.
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Non-Agency Pass-Through
Credit enhancement to AA or AAA.
Overcollateralization
Senior/subordinated structure
shifting interest structure
months
% of prepayment to senior
1-60
70
61-72
60
73-84
40
85-96
20
97-108
12
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Prepayments
Prepayment speed, conditional prepayment
rate CPR.
Single-Monthly mortality rate SMM.
SMM = 1 - (1-CPR)1/12
A general model should be based on a
dynamic transition matrix, very similar
to credit migration.
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Prepayments
Prevailing mortgage rate relative to original.
Path of mortgage rates.
Level of mortgage rates.
Seasonal factors (home buying is high in
spring summer and low in fall, winter).
General economic activity.
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Bond Equivalent Yield
Bond equivalent yield = 2[ (1+yM)6 - 1]
Yield is based on prepayment assumptions
and must be checked!
PSA benchmark = Public Securities
Association. Assumes low prepayment rates
for new mortgages, and higher rates for
seasoned loans.
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Special Properties
Negative convexity - if interest rates go up
the price of a pass through security will
decline more than a government bond due to
lower prepayment rate.
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CMO and stripped MBS (ch. 12)
Collateralized Mortgage Obligations - are
bond classes created by redirecting the cash
flows of mortgage related products so as to
mitigate prepayment risk.
CMO is backed by a pool of pass-throughs,
whole loans, or strips, structured in order to
serve different types of clients.
The bond classes are called tranches.
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CMO Example
Since 1983 - sequential-pay CMO. Each class
is retired sequentially.
Example: collateral is a pass-through with
• par of $400M
• pass-through coupon rate 7.5%
• WAC weighted average coupon 8.125%
• WAM weighted average maturity 357 mo.
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CMO Example
4 tranches A,B,C,D divide the whole nominal,
coupons will be distributed proportionally, but
principals first go to A, until repaid, then to B,
etc.
Another example is an accrual CMO when
one of the tranches does not get receive
current interest. It is accrued and added to the
principal.
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CMO Example
Some tranches are floaters, others inverse
floaters.
Floater: Variable Rate + spread
Inverse Floater: Spread - Variable Rate
Often LIBOR is used as variable rate.
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Other CMOs
PAC = Planned Amortization Class,
IO = interest only,
PO = principal only,
IO, PO strips.
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ABS Asset-Backed Securities (13)
Collateral,
credit enhancement,
Payment structure (priorities),
legal structure (SPV=special purpose vehicle)
Auto loan backed securities
Credit Card backed securities
Home Equity loans (second lien)
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