Chapter 14: Comparing Investment Alternatives

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Chapter 14 Comparing Investment Alternatives

• Andrew Davidson
• Anthony B. Sanders
• Lan-Ling Wolff
• Anne Ching

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MBS

• Passthrough MBS are the building blocks of the
  mortgage investment world.
• Passthroughs may have a variety of investment
  characteristics.
• Table 14.1 shows summary risk and value measures
  for Ginnie Mae and Fannie Mae 30 year passthrough
  mortgages.
• The instruments ranging from the lowest coupons
  to the highest are offered at increasing prices.
• They offer investors a wide range of spread and
  average life combinations.

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Passthrough investment characteristics
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Passthrough investment characteristics

• The wide range of investment results is clearly
  demonstrated by the chart.
• The lower coupons have returns that are very
  sensitive to interest rate levels, while the
  higher coupons show more stable profiles.
• The impact of negative convexity is clearly
  visible as the upward movement in returns is
  limited.

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IO/PO

• Structuring offers the opportunity to
  significantly alter the investment
  characteristics of MBS.
• Interest only (IO) and principal only (PO)
  securities are a special example of the power of
  structuring.
• Splitting the MBS into its principal and interest
  components produces two new instruments that have
  very different investment profiles from the
  underlying collateral.
• Figure 14.2 shows the total return profiles of IO
  and PO securities created from the Fannie Mae 6
  MBS shown in Table 14.1 and Figure 14.1.
• The PO is a very bullish security that benefits
  greatly from falling interest rates. The IO is a
  bearish security that benefits from rising
  interest rates.

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IO/PO investment characteristics
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IO/PO investment characteristics

• The varying performance of IOs and POs can also
  be seen using total return analysis.
• Figure 14.3 shows the total returns of the IOs
  and POs shown in Table 14.2.
• The instruments show a wide range of bullish and
  bearish profiles. They also show varying degrees
  of negative convexity.

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Total return profiles
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CMOs

• CMOs offer virtually an unlimited range of
  investment choices.
• The range of choices is clearly shown when
  comparing the investment characteristics of
  various Agency CMO securities contained in Table
  14.3.
• The table shows various types of CMO classes
  issued from five different CMO transactions, each
  backed by different collateral.
• The examples range from a PAC (planned
  amortization class), support, sequential bonds to
  inverse floating bonds.
• PACs are bonds that have a planned amortization
  schedule.
• Sequential bonds are bonds whose principal is
  paid down first before principal is paid to other
  classes of bonds.
• Support bonds are created in conjunction with PAC
  bonds and receive the remaining principal
  payments.
• Inverse floating IOs (Inverse IOs) are bonds
  whose coupons move inversely with an index.

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Investment characteristics of agency CMOs
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Collateral characteristics

• The characteristics of the collateral backing
  these five transactions are summarized in Table
  14.3.
• Two of the transactions are backed by FNMA
  collateral with a 5.5 coupon and the remaining
  transactions are backed by FHLMC collateral with
  5.5 and 6.0 coupons.
• Prepayment variability in various interest rate
  environments is measured along the left-axis in
  terms of CPR and along the right-axis in terms of
  WAL for each respective CMO collateral group (see
  Figure 14.4).

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Collateral characteristics
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CMO prepayment and average life profiles
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CMO total return analysis