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Zvi Wiener

02-588-3049http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

Fixed Income 3

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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.


Government-Sponsored Enterprises

GNMA - Government National Mortgage Association

FHLBS - Federal Home Loan Bank System

Sallie Mar - Student Loan Marketing Association


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.


Corporate Bonds

Main types of issuers

• utilities

• transportation

• industrial

• banks and financial companies


Bond Indentures

• trustee

• term bonds, serial bonds

• collateral

• debenture bond - not secured

• guaranteed bonds


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.


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


Bond Rating

• Duff and Phelps Credit Rating Co.

• Fitch Investors Service

• Moody’s Investors Service

• Standard & Poor’s Corporation


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-


Rating

• BBB- or better = investment grade

• BB+ and below - speculative grade

• D to DDD default

• transition matrix


One year transition matrix

Aaa Aa A Baa Ba B C&D

Aaa 91.9 7.38 0.72 0 0 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

Baa 0 0.2 5.4 87.9 5.5 0.8 0.2


High Yield Bonds

• LBO, downgrading, refinancing

• fallen angels

• deferred interest bonds

• Step-up bonds pay initially low interest which increases with time


SEC rule 144A

Allows to trade private placements among

qualified institutions.


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!


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.


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.


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.


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


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


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


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.


Municipal Securities

Exemption of interest income from federal

taxation.

Issued by states, counties, special districts, cities,

towns, school districts.



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



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


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


Municipal Money Market Products

• TAN = tax anticipation notes

• RAN = revenue anticipation notes

• GAN = grant anticipation notes

• BAN = bond anticipation notes

• Tax exempt commercial paper


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


Yield on Municipal Bonds

tax-exempt yieldequivalent taxable yield =

1-marginal tax rate

for example bond offers 6.5% and marginal tax rate 40%:

0.065 = 0.1083

1-0.40


Non-US Bonds

• national bond markets– domestic market

– Foreign marketYankee USA Samurai Japan bulldog UK Rembrandt Holland matador Spain


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.


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.


Eurobond market

• Floating Rate Notes = FRN based on LIBOR or LIBID

• many are collared

• some are perpetual


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%


Japanese Government Bonds JGB

• short term Treasury bills

• medium term bonds

• long term bonds

• super long term bonds (20 years)


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


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)


Brady Bonds

Argentina, Brazil, Costa Rica, Dominican Republic, Ecuador, Mexico, Uruguay, Venezuela, Bulgaria, Jordan, Nigeria, Philippines, Poland.

Partially collateralized by US government securities


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


Fixed Income 3

• Mortgage loans

• Pass-through securities

• Prepayments

• Agencies

• MBS

• CMO

• ABS


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.


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.


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.


Fixed Rate Mortgage

A series of equal payments with PV=loan.

Example: 100,000 for 20 years with 6% and equal monthly payments.

20*12

1

1206.0

1

000,100i

i

x


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.


Balloon Mortgage

One payment at the end.

Sometimes they have renegotiation points.


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.


Risk in Mortgages

Default risk

Liquidity risk

Interest rate risk

Prepayment risk


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.


Prepayment Risk in Mortgages

Sale of home

Better interest rates

Irrational factors


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


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.


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.


Non-Agency Pass-ThroughCredit enhancement to AA or AAA.OvercollateralizationSenior/subordinated structure

shifting interest structuremonths % of prepayment to senior1-60 7061-72 6073-84 4085-96 2097-108 12


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.


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.


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.


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.


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.


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.


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.


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.


Other CMOs

PAC = Planned Amortization Class,

IO = interest only,

PO = principal only,

IO, PO strips.


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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