Zvi Wiener

1
Fixed Income 3

• Zvi Wiener
• 02-588-3049
• http//pluto.mscc.huji.ac.il/mswiener/zvi.html

2
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.

3
Government-Sponsored Enterprises

• GNMA - Government National Mortgage Association
• FHLBS - Federal Home Loan Bank System
• Sallie Mar - Student Loan Marketing Association

4
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.

5
Corporate Bonds

• Main types of issuers
• utilities
• transportation
• industrial
• banks and financial companies

6
Bond Indentures

• trustee
• term bonds, serial bonds
• collateral
• debenture bond - not secured
• guaranteed bonds

7
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.

8
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

9
Bond Rating

• Duff and Phelps Credit Rating Co.
• Fitch Investors Service
• Moodys Investors Service
• Standard Poors Corporation

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Rating

• Moodys SP Fitch DP
• 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

12
One year transition matrix

• Aaa Aa A Baa Ba B CD
• 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

13
High Yield Bonds

• LBO, downgrading, refinancing
• fallen angels
• deferred interest bonds
• Step-up bonds pay initially low interest which
  increases with time

14
SEC rule 144A

• Allows to trade private placements among
  qualified institutions.

15
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.

17
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.

19
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

21
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

22
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.

23
Municipal Securities

• Exemption of interest income from federal
  taxation.
• Issued by states, counties, special districts,
  cities, towns, school districts.

24
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

25
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

28
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

31
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.

32
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.

33
Eurobond market

• Floating Rate Notes FRN based on LIBOR or
  LIBID
• many are collared
• some are perpetual

34
Comparing Yields

• bond equivalent yield of Eurodollar bond
• 2(1yield to maturity)0.5-1
• for example A Eurodollar bond with 10 yield has
  the bond equivalent yield of
• 21.100.5-1 9.762

35
Japanese Government Bonds JGB

• short term Treasury bills
• medium term bonds
• long term bonds
• super long term bonds (20 years)

36
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

37
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)

38
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

41
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.

42
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.

43
Mortgage Services

• Collecting payments, maintaining records
• Servicing fee - of outstanding plus some other
  benefits.
• Mortgage insurer required when LTVgt80.
• Credit life - voluntary life insurance.

44
Fixed Rate Mortgage

• A series of equal payments with PVloan.
• Example 100,000 for 20 years with 6 and equal
  monthly payments.

45
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.

46
Balloon Mortgage

• One payment at the end.
• Sometimes they have renegotiation points.

47
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.
• LTVgt80 in 40 of loans
• LTVgt90 in 15 of loans
• different state laws give different
• rights to lenders.

50
Prepayment Risk in Mortgages

• Sale of home
• Better interest rates
• Irrational factors

51
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

52
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.

53
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.

54
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

55
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.

56
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.

57
Bond Equivalent Yield

• Bond equivalent yield 2 (1yM)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.

58
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.

59
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.

60
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.

61
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.

62
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 (SPVspecial purpose vehicle)
• Auto loan backed securities
• Credit Card backed securities
• Home Equity loans (second lien)