Chapters 7/8 Flashcards
Munis are exempt from filing provisions of the Securities Act of 1933, state and federal registration requirements, and antifraud provisions?
False, munis are exempt from filing provisions of the Securities Act of 1933, state and federal registration requirements, but not antifraud provisions.
True or false: Munis are exempt from federal taxes and often are not taxed within their own state?
True
General obligation (GO) bonds
Bonds issued by a municipality and are backed by the full faith & credit of that municipality. Only issuers that can levy taxes can issue GO bonds. Issuers MUST obtain voter approval to issue GO bonds since taxpayer money is being used to service the bonds.
- GO bonds are repaid through tax income and other fee income (parking fees, etc.)
Ad valorem tax
A property tax based on the assessed value of the piece of RE multiplied by the tax rate. This is expressed in terms of mills (mills does not mean millions).
Ex: Assessed value of preoprty is $300k and subject to a tax of 7 mills = ($300k * .7%) = $2.1k.
Limited tax GO bonds vs unlimited tax GO bonds
Limited tax GO bonds= There is a legal limit on the tax rate that may be assessed.
Unlimited GO bonds= There is no legal limit on the government’s taxing power.
Considerations when assessing the credit risk of a GO bond
- Economic health of the municipality
- Tax burden and source of payments
- Municipality’s budget
- The issuer’s existing debt
- Keep in mind, although a city may lose some of its population to its suburbs, it still may retain its economic strength as a place of employment
Unfunded pension liabilities
When the money available is less than the amount required to pay pension liabilities. This has a negative impact on an issuer’s credit quality.
Debt statement
A tool available for those analyzing the debt of a municipality. The various components of the debt statement are:
* Direct debt
* Net direct debt
* Overlapping debt
* Total bonded debt
Direct debt
All the debt that’s been issued by the municipality.
Net direct debt
The direct debt minus any self-supporting debt.
Overlapping debt
A municipality’s proportionate share of debt with other municipalities that are located within the geographic limits of the issuer. The debt is generally based on the assessed values of the municipalities.
Overlapping debt = Net overall debt - Net direct debt
Overlapping debt worsens the credit rating of the issuer
Total bonded debt
The sum of both LT and ST debt of a municipality plus applicable share of overlapping debt.
Common ratio used when comparing debt of different communities
(Net direct debt + overlapping debt) ÷ assessed value OR population.
Revenue bonds
Bonds issued to finance a specific project. Fees collected from these projects are used to make payments on interest and principal.
- Revenue bonds may be issued when voter approval for GO bonds cannot be obtained.
Special tax bonds
Revenue bonds where a bond funds a project and an excise tax is used to pay interest and repay principal.
Special assessment bonds
Revenue bonds that are payable only from an assessment on those who directly benefit from the facilities (ex: sewer systems, water systems, etc.) The tax is based on the property value of each person who derives a benefit.
Moral obligation bonds
Revenue bonds that are first secured by the revenues of the project, but if these revenues are insufficient then the state is morally obligated (but NOT legally obligated) to pay interest and repay principal.
Legislative approval must be obtained to issue these bonds.
Lease rental bonds
Revenue bonds where the bonds fund a project that is then leased to another entity. For instance, a municipality issues a bond to build a dormitory and then leases that dormitory to a college. The leasing revenue from the college will pay interest and principal on the bond.
- If the lease payment is subject to an annual budgeting process, credit risk is tied to the willingness of the issuer to budget these payments annually.
Certificates of participation (COPs)
A method of financing used by governments for public facilities, offering an alternative to traditional bonds. They represent an investor’s share in the lease payments of a specific project, effectively providing investors with an interest in the revenue generated by the lease. COPs don’t require voter approval and can be issued more quickly than bonds.
Industrial development bonds (IDBs)
Bonds issued by a municipality and secured by a lease agreement w/ a corporation. The purpose of the bond is to build a facility for the corporation.
- The security’s credit rating is dependent on the financial health of the corporation.
- If the corporation is a substantial user of the facility, then the federal tax exemption does NOT apply!!!
Private Activity or Alternative Minimum Tax (AMT) Bonds
Bonds where 10% or more of the bond proceeds are used to finance a project for a pvt. entity (corporation or sports team) AND 10% or more of the proceeds will be secured by the property
The interest earned on a private activity bond is taxable at
the federal level unless the bond is deemed to be a qualified private activity bond. To be considered qualified, the bond must meet certain standards and be publicly approved.
* These bonds are generally revenue bonds.
- The possibility that the bonds may be subject to taxation is reflected in the yield at which the bonds trade.
AMT Question:
A client who is in the 35% tax bracket and subject to the AMT is able to purchase an AMT municipal bond yielding 4.70% or a non-AMT municipal bond yielding 4.35%. Which bond will offer the highest after-tax yield?
For the AMT bond, the after tax-yield = 4.70% * (1-.35) = 3.05%
For the non-AMT bond, the after-tax yield is 4.35%
Situations where munis are NOT exempt from federal tax:
- When proceeds are used to build a sports facility or certain types of housing
- Offerings designed to allow issuers to borrow funds to replinish unfunded pension liabilities.
These are called taxable municipal bonds
Build America Bonds (BABs)
A taxable municipal bond that only existed in 2009 to help municipalities fund capital projects at lower costs to entice fixed-income investors. W/ these, the U.S. Treasury repaid a portion of the interest on the bonds.
Double-barreled bonds
Munis backed by a specific revenue source and the full faith and credit of the taxing authority. A combo of tax revenue and income from the project are used to pay the debt service.
Parity bonds
When two or more issues of revenue bonds are backed by the same pledged revenues.
Legal opinion
A written document that assures investors that the issuer has the legal right to issue the bonds. Every muni issue must be issued w/ a legal opinion.
Unqualified legal opinion
When there are no existing situations that could adversely affect the legality of an issue.
- Potential adverse situations include an issuer of a revenue bond not having a clear title to a property or an issuer that’s violating local, state, or federal statutes when developing a project.
Feasibility Study
When issuing revenue bonds, the municipality must hire a consulting engineer to ensure that the project will generate enough revenues to cover the debt service.
Net revenue pledge vs Gross revenue pledge
Net revenue pledge= When the operating and maintenance expenses are deducted from the gross project revenues before the revenues are applied to debt service.
Gross revenue pledge= When the revenues applied to the debt service are gross any expenses.
- Under a gross revenue pledge, the debt service expenses are paid first. In the more commonly used net revenue pledge, operating and maintenance expenses are paid first, followed by debt service expenses.
Debt service coverage ratio (DSCR)
The amount of available revenue to the amount of revenue needed to satisfy the debt service requirement.
Bond indenture/Bond resolution/Trust agreement
A contract between an issuer and a trustee that has been appointed to represent the bondholders’ interests. The indenture contains various provisions that establish the issuer’s responsibilities and bondholders’ rights.
Typical bond covenants (promises)
- Rate covenant
- Maintenance covenant
- Insurance covenant
- Perform financial reports and audits
- Issuance of additional bonds
- Non-discrimination covenant
- Catastrophe call
- Credit enhancement
- Flow of funds
Don’t need to memorize this list. Just know what each of them are.
Rate covenant
The issuer’s pledge to maintain user fees at a level that’s sufficient to meet operational costs, debt service, and certain reserve funds.
Maintenance covenant
The issuer’s pledge to maintain the project in good working order
Insurance covenant
The issuer’s pledge to maintain insurance on the property
True or false: If there’s a closed-end indenture, no additional bonds that have an equal claim on the pledged revenues may be issued against the same security. However, if there’s an open-end indenture, additional bonds may be issued in the future for expansion of the project?
True
Non-discrimination covenant
The issuer’s pledge that no special rates will be granted to any person/group
Credit enhancements
Credit from entities other than the issuer may be obtained to provide security for the debt financing. This may come in the form of bond insurance, letter of credit, or state (or other) government guarantees.
Flow of funds covenant
Establishes the priority for which the municipality will use gross revenues.
True or false: On the test if they don’t tell you, assume they’re talking about a net revenue pledge bond?
True
Differences in what analysts consider when deciding the credit risk of GO bonds vs revenue bonds:
GO bonds: Conditions of the municipality
Revenue bonds: DSCR, the bond indenture, covenants, and the flow of funds.
Municipal notes
ST municipal issues that are used to finance a project. Interest is tax-exempt. Municipal notes ultimately pay interest at maturity.
Tax anticipation notes (TANs)
A type of municipal note. These are issued to finance current muni operations in anticipations of future tax receipts from property taxes. Usually GO bonds.
Revenue anticipation notes (RANs)
Same as TANs but revenues are usually federal or state subsidies. Usually GO bonds.
- Tax and Revenue Anticipation Notes (TRANs) are when TANs and RANs are issued together
Bond anticipation notes (BANs)
A type of municipal note. Issued to obtain financing for projects that will eventually be financed through the sale of LT bonds.
Grant anticipation notes (GANs)
A type of municipal note. These are issued in expectations of receiving funds (grants) from the federal government.
Construction Loan Notes (CLNs)
A type of municipal note. These are issued to provide funds for a construction project that will eventually by funded by a bond issue.
Moody’s vs S&P ratings for municipal notes
Moody’s (best to worst)
MIG 1: Superior credit quality- Investment grade
MIG 2: Strong credit quality- Investment grade
MIG 3: Acceptable credit quality- Investment grade
SG: Speculative grade credit quality- non-investment grade
S&P
SP-1+: Very strong capacity to pay interest and repay principal
SP-1: Strong capacity to pay interest and repay principal
SP-2: Satisfactory capacity to pay interest and repay principal
SP-3: Speculative capacity to pay interest and repay principal - non-investment grade
Auction rate securities (ARSs)
LT investments w/ a ST twist- the interest rates/dividends are reset at frequent intervals through auctions. Generally come in 2 forms: LT bonds (maturities of 20-30 years) and preferred shares w/ a cash dividend.
The interest/dividend rate is determined through a Dutch Auction process where the investor can choose to hold at market (keep the security regardless of what rate is set at the auction), hold at rate or bid (keep the security depending on the rate set at the auction), or sell (sell the entire position regardless of the rate that’s set at the auction).
Do NOT include a put provision
- Investors who purchase ARSs are looking for investments that are cash-like but pay higher yields than money-market funds or CDs.
Auction process of ARSs
The auction sets the lowest interest rate that will clear the market (“net clearing rate”).
Essentially, people who want to sell their ARSs put them up for sale at these auctions. The buyers state the interest rate at which they would be willing to buy. The auctioneer starts w/ the lowest interest rate and increases the rate until all the bonds that were put up for sale are sold. The clearing rate that determines the interest rate/dividend is the lowest rate where all the securities will be sold. If a bidder bids below the clearing rate, they will receive the ARSs that pay the clearing rate, and if the bidder bids above they get nothing.
The auction may fail when there’s not enough bids to purchase all the securities being offered. When an auction fails, the existing holders will continue to hold their securities.
- A firm must disclose to their clients that ARSs may not have immediate access to their funds if an auction fails.
Variable rate demand obligations (VRDOs)
A LT security marked as a ST investment. A VRDO’s int. rate is adjusted at specified intervals, and allows the owner to put the security back to the issuer/3rd party on these interval dates. If this is done, the investor receives par value plus accrued interest. The rate set at interval dates is a rate that allows the security to be sold at par value.
State-run 529 plans/Municipal fund securities
College savings plans funded by after-tax dollars where the money grows on a tax-deferred basis. States are responsible for designing specific plan rules (allowable contributions, investment options, and the deductibility for state tax purposes). These plans allow a front-loaded initial tax-free gift of $95k. Individuals can do this for as many beneficiaries as they want (ex: parent w/ 3 kids can gift $95k to all 3 kids’ 529 plans w/o incurring a federal gift tax).
529 plans can only be funded until the beneficiary turns 18 and must be withdrawn by the time they turn 30. The donor cannot choose the individual securities the plan invests in but 529 plans tend to have different investment options (high growth, low risk, etc.) The donor can only change the investment option of the plan no more than twice every 12 months.
These plans may be used for elementary and secondary schooling now.
- Individuals can take annual distributions of up to $10k from a 529 plan to pay for pvt. school for K-12.
- Individuals can take a tax-free $10k (lifetime limit) to repay student loans.
- If a non-qualifying distribution is taken, there’s a 10% penalty.
Disclosure requirements for 529 plans
- Disclose the risks and costs
- Provide a disclaimer suggesting that customers read the official statement
- Recommend that clients check w/ their home state to discover if it offers tax benefits
- There’s no requirement to provide the name and contact information of the Municipal Securities Principal who will approve customers’ investments in the plan.
529 ABLE plans
529 plans for people w/ disabilities. Maximum contribution is $19k per year and frontloading is NOT permitted. The individual’s other disability payments will continue if the 529 able account doesn’t exceed $100k.
Distributions from a 529 ABLE plan are tax-free if used for qualified medical purposes.
Local government investment pools (LGIPs)
Investment pools created by state and local governments to provide municipalities a place to invest funds. The pools provide liquidity and minimal price volatility, but ARE NOT OPEN TO THE PUBLIC
Prepaid tution plans
A type of college savings plan where a donor can buy college credits that locks in tuition costs at college levels. In other words it protects again future cost increases. These are NOT self directors, nor does it guarentee that the kid will get into university.
True or false: If an investor buys an in-state muni, the interest earned is exempt from federal, state, and local income taxes?
True. If an investor buys an out-of-state muni, it’s still exempt from federal tax but may be subject to state and local taxes.
Triple-tax-exempt bonds
Bonds issued in U.S. territories. These are exempt from federal, state, and local taxes.
Bank-Qualified (BQ) issues
Bonds that attempt to entice banks to invest by allowing banks to deduct 80% of the interest cost paid to depositors from the money used to purchase the bonds. The interest-income on BQ bonds is tax free.
BQ issuers can only issue $10mm per year.
- Typically sold at a discount.
Treasury arbitrage restrictions
Since munis are tax-exempt, they can normally be issued at lower rates than Treasuries. This presents an arbitrage opportunity for municipalities who can issue bonds and use the proceeds to invest in Treasuries at higher rates. Treasury Arbitrage Restrictions prohibit this.
Net (after-tax) yield
Measures the amout that investor will retain after paying taxes on a bond.
Net yield = Taxable yield * (1 - tax bracket)
Taxable equivalent yield
Measures how much return an investor would need to earn on a taxable bond to equal a tax-free bond.
Muni yield ÷ (1 - tax bracket)
Ex 1: Investor A lives in CA and is in the 25% federal tax bracket and is subject to a 3% state income tax on a 4% Sacramento muni. What is the taxable equivalent yield?
Since the bond is purchased by a resident of CA, they are exempt from the state tax: 4% ÷ [ 100% - 28% (25% + 3%) ] = 5.55%
Ex 2: Investor A lives in MO and is in the 25% federal tax bracket and is subject to a 3% state income tax on a 4% Sacramento muni. What is the taxable equivalent yield?
4% ÷ (100% - 25%) = 5.33%
In the denominator, it’s 1 minus anything that’s exempt
True or false: Capital gains on munis are tax-exempt?
False
3 classifications of muni issues
- Original issue discount (OID) bonds
- Secondary market discount bonds
- Premium bonds
Original Issue Discount (OID) Bonds
Munis that’re issued at a deep discount. Each year the accretion is treated as interest for tax purposes and is added to the bondholder’s cost basis. This accretion is NOT taxable, and thus OIDs are suitable for tax-sensitive customers.
If an OID is held until it matures, then the cost basis will equal par. If it’s sold prior to maturity, the cost basis is used to calculate capital gains/losses and will be taxed.
- If the exam mentions a zero-coupon muni, it’s referring to an OID.
- In reality, the method of accretion is calculated using the constant yield method but for the sake of the exam we just use straight line method.
OID sold prior to maturity example:
An OID is sold prior to maturity at $700 w/ 10 years to maturity. 5 years later the bond is sold for $880. What is the tax implications?
($1k par - $700 cost) = $300 discount
$300 discount ÷ 10 years = $30 accreated each year (NOT taxable)
$700 original cost + ($30 * 5) = $150 accumulated accretion = $850.
$880 - $850 = $30 capital gain (taxable)
Secondary market discount (SMD)
When a muni is purchased at a discount in the secondary market. If this bond is then held until it matures, there will be a taxable gain at maturity that’s taxed at the ordinary income rate.
W/ SMDs, accretion IS taxable as ordinary income!!
Premium bond
If a bond is purchased at a premium, it must be amortized each year. Amortization is not deductible for tax purposes.
If a premium bond is held until it matures, the cost basis will equal par. If it’s sold prior to maturity, just like an OID or SMD, there will likely be a capital gain/loss.
Premium bond example:
A bond is purchased for $1,050 w/ 10 years to maturity. 5 years later, the bond is sold for $1,030. What are the tax implications?
($1,050 cost - $1k par) = $50 premium
($50 premium ÷ 10 years to maturity) = $5 of amortization per year
$5 * 5 years = $25 of accumulated amortization when the bond is sold
$1,050 original cost - $25 accumulated amortization = $1,025 cost basis
$1,030 - $1,025 = $5 capital gain
Tax swap
Selling a bond at a loss, and then either before or shortly after the sale repurchasing a similar bond. In order to avoid the wash sale rule, the investor must repurchase bonds that have material differences from the bonds that were originally sold.
- Swapping may also be done for non-tax reasons, such as to change a portfolio’s maturity or to enhance its quality or yield.
Order qualifiers that sellers can request w/ munis
- All or none (AON) = a type of order where the buyer must buy all of the securities being offered.
- Fill or kill= A type of order where the buyer must either buy the securities at the offering price of the quotation will be withdrawn.
Understanding muni quotation terminology
100M New York State 4.00 7-1-40 @ 6.25 C30 @ 100
- 100M = $100k
- 4.00 = 4% coupon rate
- 7-1-40 = July 1, 2024 maturity date
- 6.25 = YTM (a.k.a. basis)
- We assume this is a GO bond since it’s not specified. Revenue bonds MUST be specified in the quotation
Out firm and recall
Out firm essentially means that a muni seller (dealer) is commited to keeping the quotation for a set period of time. Recall is like a provision to this where if the dealer changes their mind within a set period of time then they can withdraw the offer.
- According to the MSRB, if a dealer doesn’t intend to buy or sell securities based on a quote given, it must identify the quote as subject (to confirmation), nominal, or workout.
Non-marketable (non-negotiable) vs marketable (negotiable) bonds
Non-marketable/non-negotiable: These are savings bonds. They cannot be sold in the secondary market.
Marketable/negotiable: Treasuries that can be sold in the secondary market.
These are the two major groups of U.S government debt issues
Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds)
T-Notes have maturities that range from 2-10 years, while T-Bonds have maturities > 10 years. Both have minimum denominations of $100 but par is usually $1k. T-Notes and T-bonds, like other bonds, are quoted as a % of par, however government securities are quoted in increments of 1/32nd of a point, while most other bonds are quoted in incrementes of 1/8.
Book-entry vs street-name holding
Book-entry means an investor never actually receives a paper security. This is how T-bonds and T-notes are done. The Fed enters the names of the owners in its records.
Street-name holding is when the security is held in the name of a BD at a depository, such as the DTCC. A street-named security can be re-registered in the name of a client at their request.
Treasury Inflation-Protected Securities (TIPS)
Treasury bonds where the interest rate is fixed, however the principal on which the interest is paid varies based on CPI. During periods of inflation, the principal levels will rise.
In any year in which a principal adjustment is made, the annual adjustment will be taxed at the federal level as ordinary income. Additionally, any interest paid will be taxable at the federal level.
TIPS may be issued as Notes or Bonds
- The total inflation-adjusted principal will be paid at maturity. Although the face amount may fall below par, TIPS will pay a least $1k at maturity.
Treasury Bills (T-Bills)
ST securities that mature in under a year. T-bills are only issued in book-entry form and are sold in minimum denominations of $100. T-Bills are ALWAYS sold at a discount to par. T-Bills don’t make interest payments.
T-Bills are quoted on a discounted yield basis, NOT as a % of par.
- Since the bid’s higher yield represents a larger discount (a lower price), the bid will appear to be greater than the ask.
True or false: The bond equivalent yield allows investors to compare the yields available on T-bills with the yields available on notes, bonds, and other interest-bearing securities?
True.
A T-Bill’s bond equiv. yield is ALWAYS higher than the discounted yield.
Treasury Strips (T-Strips)
These are Treasury bonds where the princiapl and coupon payments trade as separate securities. The bond, minus the coupons, are sold at a discount to par. The investor does not receive interest payments but is repaid the full face value when the bonds mature.
- Treasury STRIPS are issued by the U.S. Treasury and backed by the U.S. government.
- T-Strips CANNOT be purchased directly from the U.S. government, but instead must be bought from a BD.
Cash Management Bills (CMBs)
CMBs are unscheduled, ST debt offerings that are used to smooth out Treasury CFs. CMBs are issued at a discount but mature at their face value.
- The duration of a CMB may be as short as one day.
Accrued interest for Treasuries
Accrued interest is calculated on a 365 day basis.
Ex: on 3/8, an investor buys a $10k 7.5% T-Bond that matures on 12/1/2034. Assuming regular-way settlement, how many days of accrued interest do the buyer owe the seller?
Regular way settlemet starts the next business day (T + 1) until the next interest payment. So on 3/9, there were 31 days in December, 31 days in January, 28 days in February, and 8 days in March = 98 days.
- T-Bills and T-Strips are non-interest bearing and thus trade w/o accrued interest.
True or false: U.S. government securities are exempt from registration under federal, but not state laws and are subject to SEC filing requirements?
False, they’re exempt under federal and state law and exempt from SEC filing requirements.
Federal Reserve Auctions
The government sells Treasuries to buyers through weekly auctions. Securities firms bid through competitive tenders where they specify the price and/or the yield at which they are willing to buy the Treasuries. Individuals submit non-competitive tenders.
Non-competitive tenders are filled first. Non-competitive bidders agree to pay the lowest price of the accepted competitive tenders. So to clarify, the non-competitive tenders are filled first but the interest rate is determined by the competitive tenders. Thus, all bidders (competitive or non-competitve) pay the same price. This single price auction is a dutch auction.
Government-sponsored enterprises (GSEs)
Publicly chartered, privately owned organizations. Congress created these organizations to provide low-cost loans for certain populations. GSEs issue securities and the proceeds are provided to a bank to lend.
- GSEs are NOT backed by the U.S. government, but do have an implicit guarentee from the government. Thus, they have very low credit risk.
Federal Farm Credit Banks (FFCBs)
A type of GSE. Provides funds to entities that make ag loans to farmers. FFCBs offer ST discount notes and interest-bearing bonds w/ ST and LT maturities. Interest received on these securities is subject to federal tax but exempt form state and local taxes.
FHLB
A type of GSE. There are 12 FHLBs. FHLBs provide liquidity for banks. They issue discount notes (w/ maturities of 1 year or less) and consolidated bonds (w/ maturities of 1 year - 30 years). Securities issued by FHLBs are NOT backed by the U.S. government but the government is allowed to buy up to $4B of FHLB issues. Taxation of FHLB issues is the same as FFCB.
FHLB bonds are NOT guarenteed or backed by the U.S. government
Student Loan Marketing Association (Sallie Mae) (SLMA)
Provides liquidity to student loan makers as well as financing for state student loan agencies. Sallie Mae deals w/ government-backed student loans and uninsured student loans. Sallie Mae can also lend directly to schools.
SLMA bonds are NOT guarenteed or backed by the U.S. government
- Although originally created as a GSE, Sallie Mae is now a private company without
government backing and its stock is listed on Nasdaq. - Interest earned on Sallie Mae securities is subject to federal tax, but whether state and local taxation applies is determined by the state
Agencies that issue MBSs
- Ginnie Mae
- Fannie Mae
- Freddie Mac
- MBSs trade in OTC markets
Ginne Mae
Ginnie Mae is backed by the government and operates within the U.S. Department of Housing. The purpose of Ginnie Mae is to provide financing for housing. Interest on these securities is is fully taxable (subject to federal, state, and local taxes).
Fannie Mae
Buys conventional resi. mtg., mortgages from the Federal Housing Adminstration, or VA housing from lenders.
Fannie Mae is NOT backed by the government, but it is backed by the authority to borrow from the Treasury. Interest on Fannie Mae securities is fully taxable.
- Ginnie Mae MBSs have maturities that range from 25-30 years, but due to prepayments, foreclosures, and refis, the avg. life tends to be 12-14 years.
Freddie Mac
Provides liquidity to banks that are in need of extra funds to finance new housing. Essentially, Freddie Mac buys resi mtg. from banks. This occurs when credit is tight.
Freddie Mac gets the proceeds to do this by issuing MBSs. These are not backed by the government, but they’re backed by other agencies and the mortgages that are purchased. Interest of these securities are fully taxable.
Pass-through certificates
Essentially an MBS where the interest the homeowners pay on the mortgages passes through as interest received on an MBS.
Prepayment rate
Measures the speed at which mortgages in an MBS are being paid off. This rate will rise when interest rates are low and vice versa.
- MBSs do have prepayment risk.
Primary reason that investors choose agency securities over Treasuries?
Agency securities provide monthly payments. Investors can use this to supplement their income from pensions or SSN. Also, the yield on Agencies tends to be slightly higher than Treasuries.
The downside of Agencies is that the maturity of a pass-through security is unknown due to prepayment risk.
CMO
Essentially an MBS that’s broken up into tranches. Each tranche has a different int. rate, repayment schedule, and priority level. CMOs can help minimize prepayment risk. CMOs are securitized by BDs and are thus subject to registration under The Securities Act of 1933.
Int. payments are monthly and fully taxable, however the principal repayments are NOT taxable.
PSA Model
Estimates prepayment rates of MBSs and CMOs. If equal to 100, the assumption is that prepayment speed is stable, Greater than 100 indicates a prepayment speed faster than normal. Less than 100 indicates a prepayment speed slower than normal.
Plain vanilla/Sequential pay CMO
A type of CMO. Each tranche receives a monthly int. payment but only one tranche receives principal repayments at a time.
Planned amortization class (PAC)
A type of CMO. This is for more risk-averse investors. PACs provide a predetermined schedule of principal repayments, however this is dependent on prepayment speeds remaining within a certain range. The PAC tranche has the highest priority and receives principal repayments up to a certain amount before anyone else.
- Provides investors w/ greater protection from prepayment risk than a plain vanilla CMO.
Targeted amortization class (TAC)
Similar to PACs but only provide protection from contraction risk, not extension risk.
- Provides investors w/ greater protection from prepayment risk than a plain vanilla CMO.
Companion or support bonds
Tranches that are lower than the PAC or TAC tranches. Generally compensated w/ a higher yield.
Z-Tranches/Z-Bonds
Deferred interest bonds that have the longest avg. life of any tranche. During the initial phase of a Z-bond’s life, there’s no CFs but just like a zero-interest bond, interest is compounded. Z-tranches don’t receive any payment until all other tranches have been paid.
- Z-Trances have more price volatility than any other tranche.
Principal Only (PO) Securities
Principal only (PO) mortgage bonds are created by stripping the interest payments from the underlying mortgages. The POs are then sold at a deep discount. The face value is paid at maturity.
Interest Only (IO) Securities
Bonds that receive some or all of the interest portion of the underlying collateral but little or no principal. As the principal amounts paid on the underlying, the interest on IOs decline and payments get less and less until all of the principal on the underlying is repaid.
- At high rates of prepayment, it’s possible to get less money back than originally invested. On the other hand, IOs increase in value when prepayments are slow.
Floating-Rate Tranches
Tranches where the interest rates are variable. If the interest rate is adjusted by more than the change in the index, it’s a super-floater. If the interest rate moves in the opposite direction of the index, it’s an inverse floater.
Private label CMOs
When private entities (investment banks, commercial banks, etc.) issue MBSs. These are NOT agency securities, and NOT guarenteed by any agency or the government.
Private label CMOs have higher credit risk than agency CMOs & typically don’t have a AAA rating.
True or false: Investors w/ a capital preservation goal may opt for longer term investments to increase IRR?
False, if investors have a capital preservation goal (cash reserve goal), they want ST securities to reduce IRR.
True or false: MBSs are issued by the government, municipalities, and banks?
False, government agencies and banks issue MBSs but municipalities don’t.
True or false: MBSs provide tax-free income at the state level?
False, the interest from a mortgage-backed security is taxable at both the state and federal level.
True or false: Revenue bonds have maturity schedules based on the useful life of the project?
False, the maturity should be before the end of the useful life of the project.
True or false: If a muni bond has insurance, evidence of insurance is required to be disclosed on a customer confirmation?
True
