Fixed Income Flashcards
Payment-in-kind toggle note
allows the issuer to pay interest each period in either cash, in-kind, or a combination of the two
A split coupon bond
no coupon payments initially, and then pays a high coupon rate in cash until maturity, this is also known as a deferred coupon bond.
put and convertible bonds benefit the bond holder
allowing them to redeem the bond if the price falls
and
convert to equity shares if they are worth more than the maturity value
When the bank’s core Tier 1 capital ratios fall below a minimum level
bond will automatically convert into a share, boosting the bank’s equity capital
Callable bonds offer less capital appreciation potential because they’re more likely to be called when rates fall. Moreover they should offer higher income in the first place to compensate for the option
pays more tax on capital gains
Callable bonds can be called
in part or in whole (entire issue)
The source of capital to repay supranational bondholders
the repayment of previous loans made by the entity or from paid in capital from its members
An asset-backed security generally requires:
A special purpose vehicle to hold the collateral remotely from the issuer
> get a higher credit rating by ring-fencing the collateral from other obligations an issuer may have
assets are usually receivables: credit cards, student loans or mortgages
Credit cards and student loans are unsecured loans that rely on the borrower’s future income for repayment
monoline insurers
Insurance companies that specialize in providing financial guarantees
e.g. surety bonds
bond issuance process
The legal issuer may be different
By setting up a separate legal entity with its own balance sheet (SPV) an issuer can receive a higher credit rating which would typically reduce (not increase) the required yield.
Assuming the bond has an original issue tax provision, what Is the tax liability for the investor
A prorated portion of the original issue discount is included in taxable income every year until maturity
Primary market activities include
underwritten offering, private placements and best-effort public offerings
A step-up note
is a structured note with a coupon rate that rises over time
An inverse floater
is a structured note with a coupon rate that is inversely related to a reference rate
commercial paper
is typically a short-term unsecured debt instrument issued by corporate issuers
sovereign bonds
are usually unsecured,
the issuer does have the ability to use excess tax revenue (budget surplus) to fund interest payments.
Treasury bills (T-bills) are typically
> pure discount debt instruments with a maturity of 12 months at issue.
do not make explicit interest payments (zero-coupon bonds).
usually bought at a discount to par value and the investor receives the par (face) value at maturity.
Fannie Mae and Freddie Mac are best described as
Government Sponsored Enterprise (GSE) issuers
Ginnie Mae is a
federally related institution
non-sovereign bond can
> bond issuer can use the cash flows of a project (e.g. bridges and airports) that the bond was used to finance.
non-sovereign bond issuer can introduce special taxes on residents to fund bond payments.
A non-sovereign bond or non-sovereign government bond is a bond
issued by levels of government below the national level such as provinces, regions, states and cities.
Examples include municipal bonds issued in the US.
An agency bond or quasi-government bond are organizations
established by national governments to perform various functions for them.
Examples include Fannie Mae, Freddie Mac and Sallie Mae
The z-spread is used to compare
> represents compensation for credit risk, liquidity risk and option risk
measures the equal amount that must be added to each of the spot rates in a given benchmark term structure
Key rate duration helps us understand how a bond’s price will change given a
non-parallel shift in the yield curve
The probability of default is typically measured over
a 12-month horizon
not regarded as being a full securitization
> Covered bonds
no requirement for a special purpose entity since the bank makes payments directly to investors
covered bonds
> Unlike asset-backed securities that can have prepayment risk, cover pool sponsors must replace any prepaid or non-performing assets to ensure sufficient cash flows until maturity
The unique features of covered bonds, including redemption regimens, mean that they usually carry lower credit risk and offer lower yields than otherwise similar asset-backed securities
the underlying assets are kept on the financial institution’s balance sheet and are not transferred to a bankruptcy remote SPE as happens with an ABS. This means that they offer bondholder dual recourse to the issuing financial institution and the underlying asset pool
Soft-bullet covered bond
delay the default and accelerated payments until a new final maturity date, which is usually up to a year after the original maturity date
solar Asset Backed Security can be backed by
> collateralized by solar loans and leases
solar ABS can be further collateralized by a lien placed on the installed system, on the property itself, or both
A CDO is an
asset backed security whose underlying assets are a diversified pool of debt instruments such as non-investment grade corporate bonds, emerging market bonds or bank loans
Time tranching allows
for the redistribution of prepayment risk among the bond classes, with the bond classes having different expected maturities
recourse loan
The lender has a claim against the borrower for the shortfall from the loan amount and proceeds from the property sale
amortizing mortgage loan
periodic mortgage payments consist of interest and scheduled principal repayment and can be partially or fully amortizing over the life of the mortgage
loan-to-value ratio
The higher the ratio the lower the borrower’s equity and less protection the lender has for recovering the amount loaned if default occurs
prepayment in the context of mortgage loans
Any payment towards repaying principal on the loan in excess of the scheduled principal repayment
> unscheduled principal repayment.
residential mortgage loan
An amortizing loan that is secured by collateral of real estate property obliging the borrower to make a series of payments to the lender
Non-agency RMBS have no guarantee from
either the U.S. Government or by a GSE
rates paid on mortgage-backed securities
> In Europe, commercial mortgage-backed securities tend to pay a floating rate
In US, commercial mortgage-backed securities tend to pay a fixed rate
Residential mortgage-backed securities can pay either fixed or floating rates
Top-down approaches
which start by considering the overall economy can be
used by analysts to forecast income and expenses.
Bottom-up approaches
which start with the company or a unit in the company
can also be used. Time series methods are generally considered bottom-up.
Hybrid approach (most common)
combines elements of top-down and bottom-up approaches.
Financial statement modelling most often starts by considering the income
statement:
- This is because companies usually derive the majority of their income from future income generation. (P/E)
- Banks and building societies are an exception. Existing assets and liabilities held are
likely to be more relevant.
Basic features of a bond
* Issuer
- Supranational organisations, e.g. World Bank
- Sovereign national governments, e.g. U.S. Treasury bonds
- Non-sovereign (local) governments, e.g. state of California in the U.S.
- Quasi-governmental entities – agencies owned or sponsored by the government,
e.g. Federal National Mortgage Association (Fannie Mae) - Corporate issuers – sub-divided into financial and non-financial issuers
- Special legal/purpose entities – issuers of asset-backed securities
Money market securities
– bonds issued with a maturity of one year or less
Capital market securities
– bonds issued with a maturity more than a year
Perpetual bond
– bonds with no stated maturity date
- Seniority
- Seniority or priority of repayment is an important determinant of risk
- Senior debt has priority over other debt claims in the event of bankruptcy or liquidation
- Junior or subordinate debt have a lower priority than senior debt and are paid only once senior claims are settled
- Current/Running yield
- Is similar to the dividend yield on a share and is often described as an incomplete
measure of return - It is calculated as:
Annual coupon / Market price
- Yield to redemption/maturity
- Is the bond’s internal rate of return
- That is, it is the rate that equates the discounted future cash flows to the bond’s price
- Yield to maturity assumptions
- Bond is held until maturity
- All expected cash flows are received as and when promised
- Coupons are reinvested at the YTM from receipt until maturity
- Yield Curves
- yields of the bonds with different maturities and create a yield curve for a given issuer
- longer-dated bonds would have higher yields to compensate for the extra risk that longer-dated bonds have
- We can compare the yield on a corporate bond with the yield on a government bond of the same maturity to establish the credit risk of the corporate bond (diff in yield is the credit spread)
- Contingency provisions
- The most common contingency provisions for bonds involve embedded options (call and
put) and conversion to equity options - They resemble option contracts but cannot be traded separately from the bond itself (warrants can)
Bond indenture
- Legal contract that describes the form of the bond, the obligations of the issuer and the rights of the bond holders
- Source of repayment proceeds
- indenture will describe how the issuer intends to service the debt and repay principal
- Sovereign bonds – backed by the “full faith and credit” of the national government
- Governments have the right to tax economic activity
- In developed countries considered to be risk-free
- Non-sovereign debt
- Generally use the taxing authority of the issuer or cash flows from the project the bond may be financing, e.g. toll road
- Corporate bonds
- Issuers of higher credit quality usually issue unsecured bonds
- Issuers of lower credit quality often issue secured bonds – they offer investors a lien or pledge on specific assets
- Securitized bonds – repaid from cash flows of the financial assets owned by the special purpose vehicle
- Such bonds might be issued in tranches
Bond Covenants
- Bondholders cannot vote and, therefore, have limited influence over an issuer
- The exception to this are the bond covenants agreed upon when the bond is issued
- Affirmative covenants are typically administrative in nature
- Common affirmative covenants include
- How proceeds raised can be used
- Provision of timely financial reports
- Permitting bondholders to redeem their bonds above par if the issuer is acquired
- Other affirmative covenants include
- A pari passu clause – ensuring that a bond is treated in the same way as others with similar seniority
- A cross-default clause – the bond issuer is considered to be in default if they default on another debt obligation
- Negative covenants seek to ensure that an issuer maintains the ability to make interest and principal payments
- Common negative covenants include
- Limitations on investments or disposal of assets
- The new issue must not be senior to existing debt (negative pledge clause)
- Linking to financial ratios – e.g. Interest cover must be greater than 2.5x for each reporting
period - Covenant breaches might lead to a change in financial terms (e.g. an increase in the coupon rate),
accelerated payment or termination of the debt agreement
- Sinking fund arrangements (provisions)
- issuers set aside funds over time to retire the bond
- Could be set aside in a segregated cash reserve or a specific provision to retire a specific portion (e.g. 4%) of principal ever year
- Usually at random by drawing serial numbers
- Price at which they retired could be different from par
- Lowers credit risk of the issue (good for bond holders) but means possible reinvestment risk
- Bullet repayment
- entire repayment of capital occurs on maturity
- Amortizing bond
- scheduled payment of interest and principal over the life of the bond:
- Fully amortized bond – entire principal is paid over the life of the bond such that zero outstands on maturity
- Partially amortized bond – pays interest and principal over the life of the bond but principal is still outstanding on maturity
- A balloon repayment is required at maturity to retire the outstanding principal
- Floating rate notes (FRNs)
- Coupon is linked to an external reference rate such as LIBOR
- Coupon rate = Reference rate + Spread, e.g. LIBOR + 20 basis points
- 1 basis point = 0.01%
- Most floaters pay coupons quarterly in reference to a 3-month reference rate
- A variable-rate note is a FRN where the margin above the reference rate is not fixed
- Additional features that may be observed in FRNs:
- Floor – prevents the coupon from going below a specified value
- Cap – prevents the coupon rising above a specified value
- Collared FRN – combination of a cap and a floor
- Inverse floater – bond whose coupon has an inverse relationship to the reference rate
- Step-up coupon bonds
- Coupon increase by specified margins at specified dates
- Offer bond holders protection against rising rates
- Typically have a call feature where the issuer can redeem the bond at a set price on the
step-up date
- Credit-linked coupon bonds
- Coupon that changes when the bond’s credit rating changes
- Attractive to investors concerned about the future credit-worthiness of the bond issuer
- Also wider protection to poor economy given ratings tend to deteriorate in economic downturns
- However, the increasing coupon payment resulting from the downgrade creates an extra burden on issuer or even default
- Payment-In-Kind (PIK) bonds
- Allows the issuer to pay interest in the form of additional amounts of the bond issue rather than a cash payment
- Favored by issuers concerned about cash flows in the future being able to service the debt
- Used to finance companies with high debt levels
- Because of the assumed credit risk investors require a higher yield
- Deferred coupon (split coupon) bond
- Regular coupon payments occur after a set time after issue
- Issued by firms that foresee higher cash flows in the future to be able to service the debt
- Typically priced at a discount to par
- In certain jurisdictions investors may find the deferred coupon useful in managing taxes
- Index-linked bonds
- Coupon payments and/or principal linked to a specified index such as a commodity index, equity index or other index
- Inflation-linked bonds offer protection against inflation
- Coupon and/or principal is linked to an inflation index (RPI in the UK, CPI in the U.S.)
- Several methods of linking the coupon to the index have been identified, e.g. for inflation
as an example: - Zero-coupon indexed bond pays no coupon so the inflation adjustment is made via the principal repayment only.
- Interest-indexed bonds pay a fixed nominal principal at maturity but the coupon are index-linked over the bond’s life.
- Capital-indexed bonds pay a fixed coupon rate on an inflation adjusted principal, both principal and
coupon are adjusted. - Indexed-annuity bonds are fully amortized bonds in contrast to the above that are not. The interest
and principal paid in a coupon rises in line with inflation over the bond’s life.
- Callable bonds
- Issuer has the right to buy back the bond before the specified maturity date
- Beneficial to the issuer to protect against a fall in interest rates or a increase in the issuers credit quality, enabling the company to re-finance at a lower level of borrowing
- Investors that hold callable bonds have higher levels of reinvestment risk than noncallable bonds
- Details of the call provision will be found in the indenture:
- Call price
- Call schedule including any call protection (period of time the bond cannot be called)
- Make-whole provision – issuer required to make a lump sum payment equal to the present value of the remaining cash flows
- Exercise styles of callable bonds include:
- American call – bonds called any time after the call date
- European call – bonds only called on the call date
- Bermudan-style – called on specified dates after the call date
- Putable bonds
- Bond holder has the right to sell back the bond at a pre-determined price to the issuer on specified dates
- Beneficial for the bond holder who can sell the bond back when rates rise, enabling the investor to realize cash to then buy bonds with a higher yield
- Price of a putable bond will be higher (therefore yield lower) than an equivalent option-free bond
- Selling price is usually the par value of the bond
- Exercise styles are similar to those of callable bonds
- Convertible bonds
- Bond holder has the right to exchange the bond for specified number of common shares of the issuing company
- Beneficial to the bond holder
- Straight bond + Embedded equity call option
- Hybrid instrument; debt and equity features
- Able to participate in the appreciation of share price
- Downside protection (but lower yield) by receiving the regular coupon and principal of the bond (floor value)
- Key terms regarding the conversion provision:
- Conversion price = Price per share at which the convertible bond can be converted
- Conversion ratio = Number of shares the convertible bond can convert into
- Conversion value (parity value) = Current share price x Conversion ratio
- Conversion premium = Convertible bond price - Conversion value
- Warrants
- Entitles the warrant holder to buy the underlying stock (new shares) at a fixed price until the expiration date.
- An ‘attached’ option rather than an embedded option.
- Considered yield enhancements (‘sweetners’) when attached to a bond issue.
- Contingent convertible bonds ‘CoCos’
- Bonds that convert to common equity upon the downward movement of equity share price.
- Issued by several European banks; if bank’s equity falls below a specified level set by regulators. Banks have to issue more equity. CoCos will be triggered upon breach of
regulation and will automatically trigger a conversion of bonds to equity. Decreasing liabilities and increasing equity re-establishes the regulatory capital ratio.
Legal and regulatory considerations
- Bonds are subject to different legal and regulatory requirements depending on where they are issued and traded
- Domestic bond – bonds issued by entities incorporated in that country, denominated in that country’s currency
- E.g. U.S. company issuing a bond in the U.S. market in U.S.$
- Foreign bond – bonds issued by entities that are incorporated in another country in the national bond market of another country in that country’s currency
- E.g. UK company issuing bonds in the U.S. market in U.S.$, called a ‘yankee bond’
- Eurobond – Issued outside the jurisdiction of any one country and trade in a currency different from the countries in which they trade
- E.g. Japanese company issuing a yen denominated bond that trades in the U.S. (Euroyen bond)
- Typically less regulated
- Historically, Eurobonds were bearer but these days typically they (along with domestic and foreign bonds) are registered with ownership being recorded by name or serial number
- Global bond – a bond issued simultaneously in the Eurobond market and at least one domestic market
Tax considerations
- Income portion is generally taxed at investors ordinary tax rate.
- Capital gain usually treated different from taxable income. Often a more favorable rate. Also, the capital gains tax rate often gets lower the longer the bond is held for before the disposal.
- Original issue discount bond may have a portion of the discount subject to income tax.
- Some jurisdictions have a tax provision for bonds bought at a premium where the premium can be used to offset taxable income.
issuers typically issue more debt instruments than equity
instruments
- Issuers might have short-term loans or bonds to fund working capital needs or longer term debt to fund capital investment
- Essentially the universe of fixed-income products is greater than the universe of equities
< 1 year
Short-term
Default risk-free :
Treasury bills
Investment grade :
Repo
Commercial paper
Asset-Backed CP
High yield :
-
1 year – 10 year
Intermediate-term
Default risk-free :
Treasury notes
Investment grade :
Unsecured corporate bonds
ABS
High yield :
Secured corporate bonds
Leveraged loans
> 10 year
Long-term
Default risk-free :
Treasury bonds
Investment grade :
Unsecured corporate bonds
MBS
High yield :
-
< 1 year
Short-term
Default risk-free :
Financial intermediaries
Central banks
Money market funds
Investment grade :
Corporate issuers
1 year – 10 year
Intermediate-term
Default risk-free :
Financial intermediaries
Central banks
Investment grade :
Bond funds and ETFs
High yield :
Asset managers
Hedge funds
Distressed debt funds
Default risk-free :
Financial intermediaries
Central banks
Pension funds
Insurance companies
Investment grade :
Pension funds
Insurance companies
High yield :
-
fallen angels are
issuers who were formerly investment-grade but have
been down-graded to high yield
issuers who were formerly investment-grade but have
been down-graded to high yield
- Although fixed income indexes perform a similar role to equity indexes there are three important differences
- Issuers often have many bonds in issue but only a small number of equities
- Fixed income indexes, therefore, often have many more constituents
- Bonds tend to mature and, as such, there is more turnover in fixed-income indexes
- Bond indexes are usually rebalanced every month to add new issues and remove those that don’t
have long enough maturities
- Bond indexes are usually rebalanced every month to add new issues and remove those that don’t
- Bond indexes are, like equity indexes, usually weighted but by market value of debt outstanding
- Since bond indexes contain bonds issued by a wide variety of issuers, they will reflect changes to bond market composition over time
- If a bond fund wants to track a specific index it will hold a representative sample of constituent bonds because it not practical to hold all the bonds in the index
- Fixed income indexes are classified as broader aggregate indexes with many constituents, or narrower indexes, based on criteria such as sector, credit quality, time to maturity, geography or ESG characteristics
Primary fixed-income markets
- Markets in which an issuer sells a new bond to investors to raise capital
- In contrast secondary bond markets are such that investors trade bonds with each other
- A debut issuer is an issuer approaching debt markets for the first time
- The debut issuer is often replacing bank loans as a source of funding with publicly issued bonds
- The issue could be brought to market via a public offering or a private placement
- Underwriters usually conduct ‘roadshows’ to familiarize the market with the new issuer and its use of and sources of repayment for the new bond
- For repeat issuers of fixed-income securities the process is much quicker
- Issuance of unsecured investment-grade bonds usually takes place within a several-hour period
- Unlike equity issuers that issue more of the same, bond issuers often issue a new security at or close to par
- Less commonly, repeat issuers might issue the same bond at a price significantly away from par (referred to as a reopening of an existing bond)
- With an underwritten bond offering, a number of financial intermediaries (underwriters) guarantee the sale of the bond at a price agreed with the issuer
- Investors in such bonds are usually familiar with the indenture and financial statements of frequent issuers
- Issuers usually often choose issuance timing on an opportunistic basis when conditions are favourable
- Such issuers often make use of a shelf registration that is updated regularly and is used for multiple future issues
- Secured bond issuance is often a more convoluted process
- Investors must familiarise themselves with unique and more complex covenants as well
as the use of operating cash flows and collateral as sources of repayment - For lower credit quality bonds, the financial intermediary is more likely to act as a broker
on a best-efforts basis - If the bond issue is small, the issuer is less well-known or the terms are more customised the bond might be issued via private placement
- Primary market issuance of sovereign debt usually takes the form of a public
auction led by a national treasury or finance ministry
Secondary fixed-income markets
- We have seen some recent moves to electronic trading but fixed-income secondary markets are still largely quote-driven or OTC markets
- Secondary market liquidity can vary dramatically and the bid-offer spread is a key measure of liquidity
- The most recently issued, or on-the-run, developed market sovereign bonds are typically the most liquid
- Amongst corporate issuers, recently issued corporate bonds from frequent issuers of higher credit quality tend to be more liquid
- Bonds of less frequent issuers or seasoned bonds of more frequent issuers tend to be less liquid
- Seasoned bonds don’t tend to be heavily traded
- An exception that can increase trading activity in a seasoned bond is a significant deterioration in the bond’s credit quality
- Bonds of issuers close to bankruptcy (distressed debt) typically trades well below par
- Funds with strict credit quality criteria might be forced to sell and this represents an opportunity for hedge funds to potentially benefit
- Distressed debt is traded until the issuer has liquidated its assets or its outstanding bonds have been restructured
- By the time that an issuer’s debt has become distressed, its shares are likely to have been delisted
External Loan Financing for Non-Financial Corporations
- Non-financial corporations rely on financial intermediaries which includes bank and non-bank lenders
- Uncommitted lines of credit (more frequently used in the US)
- Least reliable form of bank borrowing
- A bank can offer an uncommitted line of credit for an extended period but reserve the right to refuse to honor any request to use the facility
- Their main attraction is that the only cost is interest payable
- Committed (regular) lines of credit (more frequently used outside the US)
- More reliable than uncommitted lines because banks formally commit to providing the funds as needed
- Lines are in place for 364 days
- Usually classified as “notes payable” on the financial statements
- The borrowing rate is often the bank’s prime rate or at a money market rate plus a spread
- As well as paying interest the lender will also require the borrower to pay a commitment fee
External Loan Financing for Non-Financial Corporations
- Revolving credit agreements or revolvers (more frequently used in the US)
- The most reliable form of short-term bank borrowing
- Similar to committed lines of credit but can be in place for 3–5 years (i.e. multi-year) and often used for larger amounts
- Borrowers draw down and pay back periodically
- Secured (asset-based) loans
- Assets such as fixed assets, high-quality receivables, or inventory are used as collateral for the loan
- The lender files a lien against the assets and the lien becomes part of the borrower’s financial record
- Used by companies that lack sufficient credit quality to qualify for unsecured loans
- Factoring
- The company sells its accounts receivable to a lender (the factor) at a discount
- The factor then is responsible for collecting the cash from the company’s customers
External, Securities-Based Financing for Non-Financial Corporations
- Commercial Paper
- Short-term unsecured promissory note issued in a public offer or private placement
- Funds working capital requirements, as well as interim (bridge) finance until permanent funding can be arranged
- Issued by large, highly rated companies and financial institutions, governments and supranational agencies
- Maturity ranges from overnight to one year, but is typically less than three months
- Usually, the proceeds of new commercial paper is used to pay the holders of maturing commercial paper (‘rolling over the paper’)
- Creates rollover risk (issuer fails to issue new paper)
- To protect against this risk, investors require the issuer to obtain backup lines of credit from their banks (‘liquidity enhancement’)
- Defaults are relatively rare
- U.S. Commercial paper vs. Eurocommercial paper
- U.S. Commercial paper (USCP) market is the largest and most liquid globally
- Eurocommercial paper (ECP) represents the international commercial paper market
Short-Term Funding Alternatives for Financial Institutions
- Financial institutions (banks) have greater funding needs than non-financial institutions.
- Depositary institutions have access to deposit accounts, and generally originate a greater amount of loans. The wholesale market provides various sources of capital, e.g. central bank, interbank, and CDs.
- Retail deposits
- Primary source of funding, includes both individual and commercial deposits.
- Demand deposits (checking accounts) provide highest level of liquidity (immediate access on
demand), typically zero interest. - Savings accounts, pay interest, but less liquid than demand deposits.
- Certificate of deposit
- A specified amount on deposit for a fixed term and fixed rate payable on maturity
- Maturities typically less than one year with interest paid at maturity
- They may represent a deposit that can be traded (negotiable) or not traded (non-negotiable, with
early withdrawal penalties) - Only large denomination CDs are relevant as a wholesale funding source (institutional investors)
- Negotiable CDs oriented towards the retail market are called small-denomination CDs
- CD are traded in the Eurobond market
Short-Term Funding Alternatives for Financial Institutions
- Short-term wholesale funds
- Interbank funds
- Unsecured loan and deposit market between banks, with terms ranging from overnight to one year
- The rate on funds is closely tied to a reference rate, with interest payable on maturity
- In most countries financial institutions are required to maintain reserves at the central bank
- Some banks might have excess reserves and some might have a shortage of reserves
- The imbalance is solved through the central bank funds markets where banks borrow and lend with each other at the central bank funds rate
- A bank that is unable to borrow in the interbank market may do so directly from the central bank as a last resort (discount window lending)
- If this facility is used then it might lead to more oversight from the central bank and a restriction on the bank’s activities
Short-Term Funding Alternatives for Financial Institutions
- Commercial paper
- Commercial paper issuance is dominated by banks and financial institutions
- Like corporations, banks also face rollover risk to the extent that their funding needs exceed the maturity of commercial paper outstanding
- Banks often issue a secured form of commercial paper known as asset-backed commercial paper (ABCP)
- First, a bank agrees to transfer short-term loans to an SPE in exchange for cash
- Second, the SPE issues ABCP to investors with a backup credit liquidity line provided by the bank
- This financing is not recorded on the balance sheet of the issuer
- This off-balance sheet financing benefits the bank and investors
- The bank receives cash when the CP is issued
- Investors purchase a liquid, short-term note with interest and principal payments from a loan portfolio that they would not otherwise have access to
Repurchase agreements structure
- Repurchase agreements (repo) structure
- Sale of a security with a simultaneous agreement to buy back the same security from the original buyer at a set price (repurchase price) on an agreed date (repurchase
date) - The difference between the prices represents the interest (repo rate) on a collateralized loan (the security represents the collateral)
- Terms can be one day (overnight repo), or more than one day (term repo)
- Any coupon paid during the term belongs to the security seller (cash borrower)
- reverse repoer security buyer (cash ledner)
Repurchase agreements structure
- Instead of involving a single bond, a repo might involve a specific group of securities in what is known as a general collateral repo conducted at the general collateral repo
rate - Repos might be subject to a haircut, i.e. the need to provide collateral greater than the value of the funds being lent
- This is known as initial margin and is calculated as:
Initial margin = Security Price0/ Purchase Price0 - A 100% initial margin indicates a fully collateralized loan whilst a higher margin provides for even greater initial protection
- We can also consider the reduction or haircut of the loan relative to the initial collateral value
- This is calculated as:
Haircut = (Security Price0 − Purchase Price0)/ Security Price0 - Variation margin – as the price of the underlying bond (the 5-year US Treasurynote) changes the loan can become overcollateralized or undercollateralized
- If this happens then either party can request that variation margin be paid
- The variation margin = (Initial margin x Purchase price at time t) – Security price at time t
- Repurchase agreements applications and benefits
- Repos are used for three specific reasons
- Finance the ownership of a security (REPO)
- Earn short-term interest by lending funds securely (Reverse REPO)
- Borrow a security in order to sell its short (Reverse REPO)
- Factors that affect the repo rate
- Collateral credit risk (higher risk leads to higher rates).
- Maturity term (higher term leads to higher rates).
- Collateral delivery requirements (if delivery is not to the lender, then rates are higher).
- If demand for the collateral is higher, the lower the repo rate. On-the-run issues usually have lower rates.
- Interest rates on alternative financing in money markets (higher rates elsewhere will lead to higher repo rates)
Risks associated with Repos
* Risks associated with repurchase agreements
- Default risk – the collateral could default
- Collateral risk – the collateral should have little or no correlation with the credit risk of the repo counterparty
- Margining risk – adverse market conditions might lead to large changes in collateral value which would lead to more margin calls and increasing liquidations
- Legal risk – the ability to enforce legal rights under a repo
- Netting and settlement risk – is it possible to offset obligations and can we actually settle the transaction
Tripartite Repos
* Tripartite repos
- Tripartite repos offer a means to manage many of these risks
- Unlike with a bipartite repo, both parties agree to use a
third-party agent in the transaction
- Unlike with a bipartite repo, both parties agree to use a
- Tripartite repos don’t take away credit risk but do create cost efficiencies by providing access to a larger collateral pool as well as specializing in asset valuation and
safekeeping- The agent administers the transaction and is responsible
for cash, securities, collateral valuation and management
as well as collateral custody
- The agent administers the transaction and is responsible
Similarities between Long-Term Investment Grade and High-Yield Issuance
- Issuers and investors consider the relative risk associated with longer-dated bonds
- Normally longer-dated bonds have higher yields than government bonds and higher credit spreads
- Investors with a 5-year investment horizon might be tempted to buy a 7-year bond to get more return but are then exposed to the price achieved when they sell it two years early
- Issuers investing in a 5-year project might be tempted to issue a 3-year bond but are then exposed to rollover risk for the final 2 years
- These trade-offs exist for both investment-grade and high-yield bonds
- Higher spreads associated with high-yield debt increase the risk-versus-return trade-off for issuers of lower credit quality
AAA
BBB
AA
A
Lower YTM proportion
due to credit spread
Fewer issuer restrictions
Unlikely to default
Bond-like cash flows
> Use financial ratios and credit ratings to determine if/when
IG issuer’s likelihood of default likely to change
BB
B
CCC
CC, C, D
Equity-like cash flows
Higher YTM proportion
due to credit spread
Issuer restrictions and/or
secured by assets
More likely to default
> Consider likelihood of default and potential loss given default given covenants, restrictions and/or security
Differences between Long-Term Investment Grade and High-Yield Issuance
- Investment-grade bonds are relatively standardized debt instruments
- Issuers often have many general obligation bonds in issue at the same time
- These might have different maturities but generally have similar terms
- The most frequent investment-grade issuers often minimize refinancing risk by staggering debt maturities over time
- This reduces rollover risk and allows for opportunistic debt issuance if, and when, conditions become more favourable
- High-yield bonds are often characterized by the existence of covenants
- The debt covenants in a bond’s indenture establish the ability to monitor issuer financial performance based on predetermined criteria
- This allows lenders to take or require action to be taken
- Investor restrictions and constraints result in far less high-yield issuer flexibility and market availability than for investment-grade issuers
- Typically, such bonds are issued for 10 years or less and have less market availability over the economic cycle
- Issuers in the high-yield market often seek to retain financial flexibility by borrowing under leveraged loans with prepayment features or issuing bonds with contingency
features - Issuers of callable bonds have the right to redeem all or part of a bond prior to maturity
- Such bonds are often issued by borrowers who believe that their creditworthiness will improve
- If this happens, they can call in the callable bond and raise cash by issuing a new bond on a
lower yield
Differences between Long-Term Investment Grade and High-Yield Issuance
- Some high-yield might be described as ‘fallen angels’
- These bonds were formerly investment-grade bonds
- The borrowers’ likelihood of financial distress is similar to that of other high-yield issuers but the bonds have investment-grade features
- They are typically non-callable with few restrictions/covenants and longer maturities
- This is because they were issued when the issuer was highly rated
- The deterioration in issuer credit quality results in a fall in price which leads to the original investors suffering losses
- The investors might also be forced to divest these bonds if they no longer meet minimum rating requirements of their portfolios
Sovereign Debt
Characteristics
- National or sovereign government issuers are distinguished by
- Their legal authority to establish and maintain a country’s public goods and services
- Their ability to tax economic activity in their jurisdiction
- Additional sources of repayment of their debt obligations include tariffs, usage fees, and cash flows from government-owned enterprises
- Public sector financial accounting standards are generally prepared on a cash basis
- For example, depreciation is usually excluded
- Developed markets (DMs) are generally characterized by strong, stable, welldiversified domestic economies
- Consistent inflows and outflows of cash generally lead to stable and transparent fiscal policy which allows sovereign issuers to issue ‘default-free debt
- Emerging markets (EMs) are usually characterized by higher growth but less stable and less well-diversified economies that fluctuate more across economic cycles
- EMs often depend on a dominant industry, such as a commodity, and may involve more state-owned or state-controlled enterprises
- Government budgets may involve investments to expand economic and social infrastructure that exceed tax revenues which leads to the need for external or supranational funding
- Currency restrictions may limit foreign investment and constrain access to longer-term maturities in domestic currency
- Sovereign debt issued in the domestic currency is usually held by domestic financial institutions and domestic investors
- External debt comprise debt from foreign supranational financial organizations and debt issuance denominated in a foreign currency held by foreign private investors
Government Debt Management
* Government debt management policies address the composition of sovereign debt
- Sovereign debt issues include:
- Short-term (1 to 12 months) securities often known as Treasury bills, issued as zerocoupon instruments which are sold at a discount to par
- Medium and long-term securities that are often known as T-Notes and T-Bonds
- Whilst not being the issuer, some sovereign governments guarantee certain other instruments that, in effect, make them a type of government debt
- Government bonds generally carry the lowest default risk and governments are usually the largest issuer in a domestic market
- Short-term government securities usually carries a lower yield due to their liquidity premium
- Short-term sovereign securities are often issued at regular intervals and standard maturities but government issuers do have a lot of flexibility which helps manage any unforeseen funding needs
- Whilst short-term sovereign debt generally offers lower yields which makes issuance attractive it also brings with it rollover risk
- In practice, governments tend to issuer debt across maturities to reduce rollover risk
- The use of medium-term and longer-term debt leads to higher borrowing costs but
also greater fiscal stability - Benefits of issuing longer-term sovereign debt include the following:
- Establishment of a risk-free benchmark for all debt of specific maturities
- Use in managing and hedging market interest rate risk
- Preferred use as collateral in repo and derivative transactions
- Government bond use in monetary policy and foreign exchange reserves
Public offerings
- Auctions
- Dealers, institutional and retail investors bid in either competitive or non-competitive auctions
- Competitive bids require the bidder to specify an acceptable price/yield, and if the auction determines a higher price/lower yield, the bidder is not offered anything
- Non-competitive bids requires the bidder to accept the price determined by the auction, and thus they will always receive the securities
- A competitive bid is either a single-price auction or a multiple-price auction
- Single-price auctions often lead to lower funding costs and wider ownership
- Multi-price auctions may result in a narrower distribution of large bids
Public offerings
- Primary dealers in government securities
* Are required to participate in auctions with competitive bids
* Often serve as the central bank’s counterparty for open market operations
* Facilitate the purchase and sale of government debt by foreign central banks and other indirect
bidders
- Once issued, sovereign debt is usually traded on OTC markets by broker/dealers
* The most recently issued bonds are known as on-the-run securities and are used for benchmark yield analyses since they are more liquid than previously issued off-the-run securities
* Due to strong liquidity, some on-the-run are traded electronically on platforms operated by private
companies
- A significant difference between trading in sovereign and corporate debt is the presence of investors in sovereign debt with varying ‘non-economic’ objectives
* Major investors in US Treasuries include the Federal Reserve, major foreign governments, state and local governments, banks and insurance companies
* These factors reduce sovereign borrowing costs versus the private sector and are most pronounced for sovereign issuers with a reserve currency
* Reserve currencies are held by global central banks and are widely used to conduct international trade and financial transactions
- Such currencies are US dollar, the Euro, Japanese yen, British pound, Swiss franc, Australian dollar and Chinese renminbi
Non-sovereign bonds
- The level and type of non-sovereign funding varies amongst countries depending on whether specific public services are provided and financed at the national,
regional or local level - Some non-government issuers can levy taxes to fund activities in their jurisdiction
- Others rely on national governments budget allocations or user fees to meet interest and principal payments
- The ability to access funding across maturities is affected by the stability of these sources of repayments
Government agencies (quasi-government entities)
- Agencies issue bonds to fund government-sponsored provision of specific public goods or services based on sovereign or local law
- The Government National Mortgage Association (Ginnie Mae) securitizes and guarantees certain mortgage loans in the US to subsidize and promote home ownership
- They issue bonds with maturities matching the expected cash flows of its guaranteed mortgages
- Typically, they can issue at a yield close to but a little higher than that of sovereign debt
Local and Regional Government Authorities
- Non-sovereign government authorities may either issue debt for general purposes or for specific projects
- General obligations bonds
- Are issued for general purposes and are used to fund public goods and services in the nonsovereign’s limited jurisdiction
- Repaid from local tax cash flows
- Revenue bonds
- Are issued for specific project financing with repayments linked to a project’s revenue stream (tolls, fees, etc.)
- Projects often include infrastructure such as roads, bridge, or tunnels
- These bonds usually involve longer-dated funding with maturities matching the expected life of the
project’s cash flows
Supranational bonds
- Examples include the World Bank, the International Monetary Fund (IMF) and Asian Development Bank (ADB)
- Created and supported by sovereign governments (member states) in pursuit of a common objective
- Fostering economic co-operation and development
- Promoting trade
- Providing financing to emerging economies
- Member states typically share decision-making authority and provide implicit and explicit support to these organizations
- Resulting in the highest credit quality and access to capital across maturities
- In other cases, supranational and sovereign organizations partner to form quasi-government agencies that can issue debt at a lower cost than an emerging market sovereign government
- Supranational issuers target bond investors in major currencies using global bond
markets
Yield-to-maturity (YTM)
= Risk-free rate + yield spread
= Benchmark + Spread
* Benchmark = Expected Real Rate + Expected Inflation Rate
* Spread = Risk Premium = Credit Risk + Liquidity Risk + Tax impact
Four relationships about the change in the bond price given the market discount rates
- Bond price is inversely related to the market discount rate (the inverse effect)
- The percentage price change is greater when market discount rates go down,
than when they go up (the convexity effect) - Lower coupons more volatile than higher coupons (the coupon effect)
- Longer dated more volatile than shorter dated bonds (the maturity effect)
Constant-yield price trajectories
price change is greater when moving closer to maturity
Matrix pricing
- An estimation process that uses quoted bonds of comparable quality to estimate the market discount rate and price of a bond that is not quoted
- The comparable bonds would have similar maturity, coupon rates, and credit quality
Effective rate =
(1+APR/m)^m -1
APRm = The nominal rate for the year given m compounds per year
APRm = Rate for the period x number of periods (m)
Fixed-rate bonds
- Comparing annual yields with different periodicities
- Convert an annual percentage rate (stated) for m periods (APRm), to an annual
percentage rate (stated) for n periods (APRn)
(1+APR/m)^m = (1+APR/n)^n
Valuing a zero-coupon bond
Price = Maturity value / (1+(Yield- to-maturity/Nperiods per year))^no. of years xN
Current/Flat yield and Simple yield
- The current yield (also known as flat yield) is a basic measure of return and is often described as being ‘incomplete’
Current Yield = Annual coupon / Bond price
> It is ‘incomplete’ for a number of reasons but in particular it doesn’t account properly for the gain or loss on the bond’s price - The simple yield is a better approximation and is often used to quote JapaneseGBs
Simple yield =coupon +⁄− annualised gain/loss / Bond price
Bonds with embedded options
Yield to call
- Bond can be repurchased before the maturity date by issuer
- Call schedule
- Shows price issuer will pay to redeem the bond on various dates
- Yield to call assumes:
- Investor holds bond to assumed call date
- Issuer will call the bond on that date
- Yield to first call
- Assume bond called in at first available opportunity
- Call price usually at a premium to par
- Bond trading at a premium more likely to be called
Bonds with embedded options
Yield to put
- Maturity date is shortened to first put date
- Maturity value is changed to put price
Measuring yield spreads off the benchmark
G-Spread
G-Spread = YTM bond – YTM government benchmark (interpolated)
- Based on yield-to-maturity
- The tenor of the benchmark and reference bond will match
Measuring yield spreads off the benchmark
I-Spread
I-Spread = YTM bond – Interest swap rate benchmark (interpolated)
- Based on the interpolated swap curve
- The tenor of the benchmark and reference bond will match
Measuring yield spreads off the spot rate curve
* Static spread/zero volatility spread/z-spread
- Static spread/zero volatility spread/z-spread
- Calculating the z-spread
- Spread over each of the spot rates in a given benchmark term structure
Measuring yield spreads off the spot rate curve
* Option adjusted spread/OAS
Measuring yield spreads off the spot rate curve
* Option adjusted spread/OAS
- Used when bonds have embedded options
OAS = Z-spread - Option cost in % terms
Option cost is positive - Investor has ‘sold’ a call option to the issuer - OAS < Z-Spread
Option cost is negative - Investor has ‘bought’ a put option from the issuer - OAS > Z-Spread
Spread measure : G
Benchmark
Reflects compensation for
Interpolated Treasure yield curve
Credit risk, option risk, liquidity risk
Spread measure : I
Benchmark
Reflects compensation for
Interpolated interest rate swap rate
Credit risk, option risk, liquidity risk
Spread measure : Zero-volatility
Benchmark
Reflects compensation for
Benchmark spot rate curve
Credit risk, option risk, liquidity risk
Spread measure : Option-adjusted
Benchmark
Reflects compensation for
Benchmark spot rate curve
Credit risk, liquidity risk
Spread/margin measures for floating-rate securities
- Discount margin
- Estimates average margin over reference rate that an investor can
expect to earn over the life of security - Step 1: Determine cash flows assuming reference rate does not change (reference rate + quoted
margin) - Step 2: Compare present value of cash flows to the full price of the bond (same reference rate for
cash flows and discounting) - Step 3: Compute discount factor, and interpret the discount margin
- Drawbacks
- Assumes reference rate will not change over life of bond
- Same reference rate used for cash flows and discounting
Money market yields
Important differences compared to the bond market yields:
Important differences compared to the bond market yields:
* Simply annualized
* Cannot be computed using standard TVM analysis
* Differing periodicities for the annual rate
* Pricing formulae:
Discount rate (DR) basis:
Present Value (PV) = Future Value (FV) (1 – (Days/Year) x DR)
DR = (Year/Days) x (FV – PV)/FV
Add-on rate (AOR) basis:
Present Value (PV) = Future Value (FV) / (1+ (Days/Year)xAOR)
AOR = (Year/Days) x (FV – PV)/PV
Bond Equivalent Yield (BEY) = (365 / 360) x AOR360
Yields can differ for all of the following reasons
- Currency (expected inflation)
- Credit risk
- Liquidity
- Tax status
- Periodicity
- Maturity
Yields can differ for all of the following reasons
* Maturity structure (term structure) analysis:
- Maturity structure (term structure) analysis:
- Spot curve on zero coupon bonds
- Bond is a ‘portfolio’ of zero-coupon bonds
- Par curve
- Sequence of yields-to-maturity such that each bond is priced at par value
- Forward curve (series of implied forward rates)
Introduction to and definition of forward rates
- Can be extrapolated from spot rates (implied forward rates)
- Represents the break-even reinvestment rate
- Used to construct the forward curve
- Notation = 2y1y = “the 2 year into 1 year rate” = One year rate starting in two years time
- Spot rates are
- YTM’s are
geometric averages of forward rates
a weighted average of spot rates
Fixed-rate bonds have three sources of return
- Receipt of promised coupon and principal on scheduled dates (credit risk)
- Reinvestment of coupon payment (interest rate risk)
- Potential capital gains or losses on bond sale prior to maturity or at maturity (interest rate risk)
Total rate of return
- Original Yield-to-maturity (hold to redemption)
- Horizon yield (sold before redemption)
- Original YTM = Horizon yield
- Reinvestment rate = Original YTM
- Sale price reflects constant-yield price trajectory (carrying value)
Effect of reinvestment rate on true return
* Effect of reinvestment rate on return realized
If reinvestment rate is Higher than YTM
Realized return will be Higher than YTM
If reinvestment rate Equal to YTM
Realized return will be Equal to YTM
If reinvestment rate Lower than YTM
Realized return will be Lower than YTM
Sensitivity of the bond price with respect to the bond’s own yield-to-maturity
* Macaulay duration
Macaulay
duration (D) = Σ (n) (PV of Cash Flows) / k x Bond Price
n = no. of periods to cash flow
k = coupon payments per year
> Macaulay duration is the weighted average time to maturity of the bond’s cash flows (hence average life), measured in years
Sensitivity of the bond price with respect to the bond’s own yield-to-maturity
Modified duration (D*)
Modified
duration (D*) = Macaulay duration / (1 + yield / k)
Sensitivity of the bond price with respect to the bond’s own yield-to-maturity
* Approximate percentage change in full price
- (- Annual modified duration) x yield change
Sensitivity of the bond price with respect to the bond’s own yield-to-maturity
* Provides a linear estimate of the percentage price change
- Tangent to the price-yield curve
Duration gap
Duration gap = Macaulay duration - Investment horizon
* If duration gap is zero: Coupon reinvestment risk offsets price risk
* If duration gap is negative: Coupon reinvestment risk dominates price risk
* If duration gap is positive: Price risk dominates coupon reinvestment risk
Calculating duration
* Approximate modified duration
- Estimate the slope of the line tangent to the price-yield curve
- Change the YTM up and down by the same amount
- Prices represent full prices (include accrued interest)
(Price if yield decline – Price if yield rise)/2 (Initial price) (Change in yield in decimal) = V- - V+ / 2 (V0) (Δy)
Calculating duration
* Approximate Macaulay duration
- Based on approximate modified duration
- Approx MacDur = Approx ModDur x (1+r)
- Prices represent full prices (include accrued interest)
Interest Rate Risk on Fixed-Rate Bonds
Observations concerning straight bonds
- Properties
- Percentage price change is not the same for all bonds
- For small changes in yield, percentage price change for a given bond is roughly the same for increases and decreases in yield
- For large changes in yield, percentage price change is not the same for an increase in yield as it is for a decrease in yield
- For a given large change in yield, the percentage price increase is greater than the percentage price decrease
- Prices go up faster than they go down
- Duration and convexity vary for each bond
- As interest rates drop duration increases
Money Duration
steps from modified duration
Once we have measured modified duration, we have a linear function which can be used to predict changes in bond price for any change in yield. But we will get errors when we use bigger changes in yield.
Price value of a basis point (PVBP/DV01)
- A version of money duration
- Used to measure interest rate risk
- Absolute value of the change in the price of a bond for a one basis point (0.01%) change in YTM
PVBP = [ PV- - PV+] / 2
- Same as estimated dollar price change using modified duration for a one basis point change in yield
PVBP = Modified duration x Price x 0.0001
Factor:
Decreasing time to coupon date, assuming constant YTM
Effect on MacDur and ModDur
Intuition
- Decreases smoothly, jumps upward after coupon paid
- When the coupon is paid, the weighting suddenly increases for next cash flows, increasing the duration
Factor:
Increasing coupon
Effect on MacDur and ModDur
Intuition
- Decreases
- Cash is returned to the investor sooner so discounting has less effect (or fulcrum moves to the left)
Factor:
Increasing YTM
Effect on MacDur and ModDur
Intuition
- Decreases
- Earlier cash flows have proportionately higher influence
on the bond price as they are discounted for shorter periods; these have shorter duration
Bond price relative to par:
Coupon > Yield (premium)
Effect on MacDur and ModDur for increasing maturity
Intuition
- Increases
- Cash flows are discounted back for longer periods so rate changes have more effect, or fulcrum moves to the right
Bond price relative to par:
Coupon = Yield (pAR)
Effect on MacDur and ModDur for increasing maturity
Intuition
- Increases
- Cash flows are discounted back for longer periods so rate changes have more effect, or fulcrum moves to the right
Bond price relative to par:
Coupon < Yield (disocunt)
Effect on MacDur and ModDur for increasing maturity
Intuition
- Usually increases
- Cash flows are discounted back for longer periods so rate changes usually have more effect, or fulcrum moves to the right. However, very long dated bonds can have a lower
duration as maturity increases
Bond :
Zero coupon
Effect on MacDur and ModDur for increasing maturity
Intuition
- Linear increase equivalent to the maturity
- The bullet redemption payment is the only cash flow, and thus has a 100% weighting
Bond :
Perpetuity
Effect on MacDur and ModDur for increasing maturity
Intuition
- Mac Dur = (1+r)/r
- The value of duration is observed from the closed form formula for Macaulay duration
Modified convexity
Modified convexity
* Duration measure suggests that the price change will be the same for increases and decreases in YTM
- Not accurate
* Convexity adjustment is required
- Used to approximate the change in price that is not explained by duration
- Second order effect
Approx Modified Convexity = (V_ + V+ - 2V0)/(V0 * changeY^2)
Convexity adjustment
Modified convexity adjustment = ½(Convexity) x (Δy)2
Convexity adjustment
Percentage change in price
Duration effect + Convexity effect = -Duration x (Δy) + ½(Convexity) x (Δy)2
Portfolio duration
* Calculated in one of two ways
- Weighted average of time to receipt of the aggregate cash flows (theoretically correct)
- Weights based on the cash flow yield (IRR)
- Cannot be calculated if future payments are uncertain (embedded options)
- Weighted average of the individual bond durations in the portfolio (common practice)
- Weights based on market values
- MacDur and ModDur for standard bonds
- EffDur for bonds with embedded options
- Assumes a parallel shift in the yield curve (limitation)
- Weighted (market value) average of duration of bonds in portfolio
D portfolio = w1D1 + w2D2 + … + wnDn
Bond sensitivity with respect to a benchmark yield curve
* Effective duration
- Essential for bonds with embedded options
- Sensitivity of a bond’s price to a 1% change in benchmark yields
- Assume no change in credit spread
(V_- V+)/2V0*changeyield
V_ = price when yields fall
V+ = Price when yield rises
V0 = Initial price
For embedded options, V(-) cannot be greater than the call price
Variations on convexity
- Modified convexity
- Ignores embedded options
- Effective convexity
- Considers embedded options
- Secondary effect of change in benchmark yield curve
Effective convexity = [V_ + V +] -2V0 / V0 * changeyield^2
Key rate duration
- Effective duration measures the change in the price of a bond if the benchmark
yield curve shifts in a parallel fashion - Key rate duration gives us further insight into how a bond’s price will change for a
non-parallel benchmark yield curve change - Key rate duration helps to identify “shaping risk” for a bond – i.e., what happens if the curve becomes flatter or steeper
Empirical duration vs. Analytical duration
- Analytical duration is estimating duration and convexity using formulae as we have in this reading
- Analytical duration assumes that government bond yields and spreads are independent and uncorrelated
- Empirical duration uses historical data in statistical models that incorporate various factors affecting bond prices
- In the ‘flight to quality’ example we assumed that benchmarks yields were stable but in reality the benchmark yield falls as government bond prices rises
- Since credit spreads rise and benchmark yields fall they tend to offset each other
- This will result in lower empirical duration estimates than analytical duration estimates
- Analytical duration => YTM = Benchmark yield (same) + Spread (incr)
- Empirical duration => YTM = Benchmark yield (decr) + Spread (incr)
Credit Risk and the Cs of Credit Analysis
- Fixed income investors face credit risk – a form of performance risk in a contractual relationship
- A borrower might default – this is default risk
- Credit risk is driven by a number of factors
- Specific factors in relation to the issuer
- General economic factors
- Analysts often assess creditworthiness using the ‘Cs of credit analysis’
- Top down factors are:
- Country, Conditions and Currency
- Bottom up factors are:
- Capacity, Capital (quantitative factors)
- Character, Covenants and Collateral (qualitative factors)
Corporate issuer :
Primary Source of Cash Flow Generation
Secondary Source of Cash Flow Generation
Sources of Credit Risk
Primary Source of Cash Flow Generation
* Business operations
* Investment and financing activities
Secondary Source of Cash Flow Generation
* Asset sales
* Divestitures
* Additional debt issuance
* Equity issuance
Sources of Credit Risk
* Economic contraction
* Strategic shifts in the business and/or market environment
* More competition
* Less pricing power
* Lower margins or losses
* High debt servicing needs
Sovereign or public entity:
Primary Source of Cash Flow Generation
Secondary Source of Cash Flow Generation
Sources of Credit Risk
Primary Source of Cash Flow Generation
* Corporate and personal taxes
* Tariffs, fees, and other government revenue
Secondary Source of Cash Flow Generation
* Newly issued debt
* Sale of public assets, privatization
Sources of Credit Risk
* Economic contraction
* Political uncertainty
* High debt servicing needs
* Expansionary economic policies
* Budget deficits
* Tax cuts
* Limited ability to collect taxes
Measuring Credit Risk
- Investors might not receive interest and redemption payments as expected
- The probability weighted shortfall is known as expected loss and is given by:
Expected loss = Probability of default (POD) * Loss severity given default (LGD)
where:
loss severity given default = (1-Recovery rate)* expected exposure
- The LGD can be expressed in monetary terms or as a percentage of the principal
- The G-spread is equal to the yield spread in basis points over a government bond
- This approximation may be expressed as:
- Credit spread ≈ POD x LGD
- Therefore, an investor is fairly compensated if the expected loss is equal to or less than the credit spread
Seniority Ranking
* Secured Debt – Lower LGD
- High EBIT Margin, High EBIT to Interest Expense, Low Debt to EBITDA, High Cash Flow to Net Debt
* Unsecured Debt – Higher LGD
- Low EBIT Margin, Low EBIT to Interest Expense, High Debt to EBITDA, Low Cash Flow to Net Debt
Credit Ratings Considerations
> Credit ratings tend to be sticky and lag market pricing of risk
Some risks are difficult to capture in credit ratings
Ratings may involve miscalculations or unforeseen changes not full captured in a rating agency’s forward-looking analysis
Factors Impacting Yield Spreads
Macroeconomic Factors
- As the business cycle improves, credit spreads narrow and investors are willing to assume more credit risk (and vice versa)
- Spreads are narrowest at or near the top of the credit cycle when participants perceive credit risk to be lowest
- Beyond the high coupons associated with high yield bonds to compensate for more risk, other reasons include:
- Portfolio diversification
- Capital appreciation
- Equity-like return with lower volatility
- Under adverse market conditions, high yield bond spreads are more susceptible to widening and may face liquidity risk which can affect the bid-offer spread
Factors Impacting Yield Spreads
Market Factors
- The yield on government debt is usually a combination of real interest rates plus an expected inflation premium
- The yield spread for corporates captures an additional premium for credit risk, liquidity risk, option risk and a potential tax impact
- These risks can change over time will alter the yield, price and return on the bond
- The total yield spread over the government benchmark reflects these components
- Issuer factors that affect liquidity risk are levels of debt and issuer’s credit quality
- In general, the less debt an issuer has outstanding and the less frequently its debt trades, the higher the market liquidity risk and the bid-ask spread
- A bond that trades more frequently and with higher volumes has less liquidity risk
- During times of crisis, market liquidity can fall sharply causing bond prices to fall and yield spreads to widen significantly
Factors Impacting Yield Spreads
Issuer-Specific Factors
- The expected financial performance of individual issuers has a dramatic effect on the level and volatility of yields and yield spreads
- Factors common to all issuers are debt coverage and leverage
- Debt coverage refers to the ability of an issuer to meet bond payments using its resources and cash flows
- Leverage measure an issuer’s reliance on debt versus other sources of financing
- Corporate issuers typically invest in long lived assets and repay debt from operating cash flows
- Sovereign issuers conduct fiscal policy and provide public goods while collecting tax to fund repayment
- Investors often evaluate the yield and yield spread of a specific issuer’s bond within the same credit rating category, within the same sector or to companies with similar business models
Factors Impacting Yield Spreads
The Price Impact of Spread Changes
- The yield on a corporate bond is a combination of the government benchmark yield and the spread and, as such, a change in either can affect the bond’s yield
- The duration and convexity of a bond are driven by benchmark yield changes and for changes in the spread
- Analysts are concerned with the interaction between benchmark yield and spread changes
- Between changes in expected inflation and the expected real rate
- Between changes in credit and liquidity risk
- Investment grade bond investors are less concerned with default risk and are more focused on spread risk
- The price impact of spread changes is driven by two main factors
- The modified duration of the bond
- The magnitude of the spread change
Factors Impacting Yield Spreads
The Price Impact of Spread Changes
- For a small change in yield spread, the price impact is approximately: (only duration effect)
%∆𝑃V (full)= −𝐴𝑛𝑛𝑀𝑜𝑑𝐷𝑢𝑟 𝑥 ∆𝑆𝑝𝑟𝑒𝑎𝑑
* For a large change in yield spread, the convexity effect should be represented: (only duration and maturity effect)
%∆𝑃Vfull= −𝐴𝑛𝑛𝑀𝑜𝑑𝐷𝑢𝑟𝑥 ∆𝑆𝑝𝑟𝑒𝑎𝑑 +1/2𝐴𝑛𝑛𝐶𝑜𝑛𝑣𝑒𝑥𝑖𝑡𝑦𝑥 ∆𝑆𝑝𝑟𝑒𝑎𝑑^2
- Price changes due to spread changes are higher for:
- Longer-duration bonds than shorter-duration dated
- Longer-dated bonds than shorter-dated dated
Sovereign Debt
- Sovereign and non-sovereign governments issue debt to fund their activities.
- Debt is used to conduct fiscal policy such as providing public goods and services
- The primary source for repayment is usually taxes and other revenue such as fees, tariffs, etc.
- Since a government can tax private economic activity within its jurisdiction it typically has the lowest credit risk of any issuer within a specific country
- Investors evaluate creditworthiness of governments and corporate issuers by:
- The stability and predictability of cash flows
- The sufficiency of those cash flows
- The issuer’s relative reliance on debt financing versus other sources
- The creditworthiness of government borrowers is based on qualitative and quantitative factors
Sovereign Credit Analysis
Qualitative Factors
Government Institutions and Policy:
Stable, predictable, executive, legal and judicial institutions and policies/Willingness to pay/Rule of Law
Fiscal Flexibility:
Ability to adjust revenues and expenditures/Fiscal discipline/Prudent use of debt
Monetary Effectiveness:
Policy credibility/Exchange rate regime/Financial system and
debt market development
Economic Flexibility:
Economic diversification/Competitiveness/Adapability to shocks
External Status:
Global currency status/Access to external funding/Geopolitical risk
Sovereign Credit Analysis
Quantitative Factors
Fiscal Strength:
Debt burden
Debt affordability
Economic Growth and Stability:
Economic growth
Cyclicality
Size and income level
External Stability:
Balance of payments
External debt burden
Currency reserves
Key Financial Ratios to Measure Fiscal Strength
Debt Burden:
Debt to GDP
𝐺𝑒𝑛𝑒𝑟𝑎𝑙 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐷𝑒𝑏𝑡/ 𝐺𝐷P
Debt to Revenue
𝐺𝑒𝑛𝑒𝑟𝑎𝑙 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝐷𝑒𝑏𝑡/ 𝑅𝑒𝑣𝑒𝑛𝑢e
Debt Affordability:
Interest to GDP
General interest payments/ GDP
Interest to revenue
General interest payments/ Revenue
Sovereign Credit Analysis
Key Financial Ratios of Economic Growth and Stability
Growth and volatility:
Avg real gdp growth
(real gdp_t-1 - real gdp_t)/real gdp_t
Real GDP Growth and volatility
standard deviation (real GDP)
Size and scale:
Per capita GDP
GDP / Population
Size of economy:
GDP in PPP terms
Sovereign Credit Analysis
Key Financial Ratios to Measure External Stability
Currency Reserves:
FX Reserves to GDP
𝐹𝑋 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠/ 𝐺𝐷P
Reserve ratio
𝐹𝑋 𝑅𝑒𝑠𝑒𝑟𝑣𝑒𝑠/ 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐷𝑒𝑏t
External Debt
External Debt Burden
𝐿𝑇 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐷𝑒𝑏𝑡/ 𝐺𝐷P
Interest to Revenue
𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐷𝑒𝑏𝑡 𝐷𝑢𝑒 𝑖𝑛 12 𝑚𝑡ℎ𝑠/ 𝐺𝐷P
Non-Sovereign Government Debt
- Sovereign issuers comprise the largest issuers of government debt but nongovernment issuers, e.g. agencies or regional government, also issue debt
- Agency debt typically carries the same credit risk as sovereign debt due to government backing
- Regional government issuers have taxation and income-generating powers and benefit from the economic and political governance as well as monetary and fiscal policies of the sovereign whose jurisdiction they fall under
- However, they have a number of features that may cause their creditworthiness to vary dramatically from the sovereign issuer (can’t print money)
- The main types of non-sovereign government issuers are agencies, public banks, supranationals (oecd) and regional governments
Non-Sovereign Credit Risk
Agencies, Public Banks and Supranationals
Agencies, Public Banks and Supranationals
* Agencies – quasi-government entities who fulfil a government-sponsored mission to provide public services
- Generally they are allowed to issue debt to finance its activities
- Rating agencies usually grant the same rating to such debt as to the sovereign entity
- Investors assume a high likelihood of sovereign government support
* Public banks – sovereign governments often sponsor the establishment of specialized financial intermediaries to promote specific sovereign, political, economic, social or other growth and policy objectives
- Similar to agencies, these are usually granted the same debt rating as the sovereign entity
* Supranationals are organizations that are established and owned by sovereign governments that share a common objective
- The World Bank and its affiliates (such as the InterntionalBankReconstructionDevelopment) issue debt to assist developing economies
* Objectives might include combating poverty or pursuing sustainable economic growth
- Others that have a regional focus include the Asian Development Bank and the Development Bank of Latin America
Non-Sovereign Credit Risk
Regional Government Issuers
- These include provincial, state, and local governments
- The bonds issued are often referred to as municipal bonds in the US and local authority bonds elsewhere
- In the Netherlands, the federal government has established a public financial institution that offers financing to municipalities and has the same credit rating as the federal government
- In other countries, a tax revenue sharing system across sovereign and local governments ensure that local authorities can meet their obligations
- In the US, municipal issuers are rated individually and typically issue either general obligation bonds or revenue bonds
Non-Sovereign Credit Risk
Types of Municipal Bonds (GO)
- General obligation (GO) bonds are unsecured and backed by the general revenues of the non-sovereign government
- They are supported by the taxing authority of the issuer
- Credit analysis of GO bonds has similarities to sovereign debt in terms of the entity having the ability to levy and collect taxes
- The attractiveness of the local business climate, presence of major industries and employers as well as possible national government support all play a role in establishing creditworthiness
- However, non-sovereign issuers may face greater exposure to technological change (declining industries) and demographic changes than sovereign governments
Non-Sovereign Credit Risk
Types of Municipal Bonds (REVENUE BONDS)
- Revenue bonds are issued to finance a specific project (e.g. a toll road) and have a higher degree of risk than GO bonds since their cash flows are dependent on a single source of revenue
- Analysis of these bonds would take into account the project itself and the financing around the project
- Analysis of the project asks:
- Is the project (e.g. a new toll road) needed and will it be used?
- Similar to a corporate bond, an analyst would consider operating results, cash flow, liquidity, capital structure and the issuer’s ability to service and repay its debt
- A key credit measure is the debt service coverage ratio
- This measures revenue available to cover principal and interest payments after operating expenses
- The higher the measure, the stronger the creditworthiness
- Minimum coverage ratio covenants are a common feature of revenue bonds
Assessing Corporate Creditworthiness
Corporate Creditworthiness
* A company’s creditworthiness depends mostly on its ability to generate profits and cash flows to service its interest and principal payments
* Analysts consider both qualitative and quantitative factors to evaluate to likelihood of default as well as the investor’s loss should such an event occur
Assessing Corporate Creditworthiness
Qualitative Factors
Corporate Governance
* Appropriate use of proceeds
* Treatment of debtholders
* Tax, accounting and covenant compliance
Business Model
* Demand, Revenue and Margin Stability and Predictability
* Asset Quality
Industry and Competition
* Structure, Concentration and Competitive Forces
* Long-Term Growth and Demand
Business Risk
Deviations from:
* Expected Demand
* Revenue or
* Margin
Assessing Corporate Creditworthiness
Qualitative Factors (Business Risk)
Business Risk
Deviations from:
* Expected Demand
* Revenue or
* Margin
Issuer-Specific
* Demand, Revenue and Margin Stability and Predictability
Industry-Specific
* Cyclicality
* Intra-Industry rivalry
* Life Cycle
External
* Macroeconomy
* Technology
* Demographic
* Government
* Geopolitics
* ESG
Assessing Corporate Creditworthiness
Quantitative Factors
Macro (Top Down) Approach
Macroeconomy:
* GDP Growth
* Cyclicality
Industry:
* Addressable market
* Market share
Event Risk:
* Scenario analysis
* External shocks
Issuer-Specific (Bottom Up) Approach
Balance Sheet
* Liquidity, Leverage
* Profitability
Cash Flow Statement
* Debt service coverage
* Interest coverage
Income Statement
* Revenue growth
* Operating profit
Hybrid approach (both bottom up and top down)
Financial Ratios in Corporate Credit Analysis
Key Financial Ratios for Corporate Creditworthiness
- Profitability
EBIT Margin: Operating income / Revenue - Coverage
EBIT to Interest Expense: Operating income / Interest expense - Leverage
Debt to EBITDA: Debt / EBITDA
RCF to Net Debt:
Retained Cash flow / (Debt - Cash and marketable securties)
Seniority Rankings, Recovery Rates and Credit Ratings
Seniority Rankings
- The debt obligations of a corporate borrower often have different seniority rankings
- Some companies and industries are straight-forward and all debt is ranked equally and issued by one operating entity
- Other companies and industries, due to acquisitions and divestitures, can have more complex debt structures
- Such businesses often have different subsidiaries that have their own outstanding debt and parent holding companies that also issue debt with different level of seniority
Seniority Rankings
Secured debt
Unsecured debt
Secured Debt (Lower LGD) - Bondholder has direct claim on certain assets and associated cash flows:
First Lien/Mortgage
Senior Secured
Junior Secured
Unsecured Debt (Higher LGD) - Bondholder has general
claim on certain assets and associated cash flows
Senior Unsecured
Senior Subordinated
Subordinated
Junior Subordinated
Seniority Rankings, Recovery Rates and Credit Ratings
Recovery Rates
- All creditors at the same debt seniority level are treated as one class
- i.e. two bondholders of the same class have the same pro rata (pari passu) claim regardless of when the debt is due to mature
- Defaulted debt often continues to trade at the expected recovery rate
- Recovery rates vary by seniority ranking based upon priority of claims
- Recovery rates:
- Vary widely by industry
- Vary depending on when they occur in the cycle, and
- Represent averages across industries and companies
- Normally the highest ranking debt gets paid out first then the next level, etc.
- However, low ranking debt and even shareholders are sometimes compensated before senior creditors are satisfied in full
- Bankruptcy resolution takes time and by agreeing to compensate lower ranking investors it can
speed up the process - During bankruptcy, legal and accountancy fees can be substantial, and the company value might fall as key employees and customers leave and competitors gain market share
- Claimants are, therefore, incentivized to compromise meaning that lower seniority investors and creditors might get more than they are legally entitled to
- In the US, it is common to look for reorganization and recovery of companies in bankruptcy
- In other markets, it is more common to liquidate companies and maximize value to bank lenders and senior creditors
Seniority Rankings, Recovery Rates and Credit Ratings
Issuer and Issue Ratings
- Credit rating agencies typically provide both issuer and issue ratings for corporate debt
- Issuer ratings are often called ‘corporate family rating’ whilst issue ratings are called ‘corporate credit ratings’
- The term ‘corporate family rating’ usually refers to its senior unsecured debt
- An issue rating reflects the seniority of the bond compared to others from the same issuer
- The probability of default for an issuer and its issues may be the same due to cross-default provisions but issue ratings may differ due to loss given default differences because of seniority, subordination and sources of repayment
- This is known as notching
Securitization
- The securitization process pools and transfers the ownership of cash flow generating assets from the original lender into a specially created legal entity
- The pool of assets are the securitized assets and are also known as the reference portfolio or collateral
- The legal entity sells securities backed by these assets and uses the cash flows from the assets to service the issued securities
Types of Securitized Products
- There are a number of different types of securitized products
- The following products are examples of Asset Backed Securities
- Covered bonds (not full securitizations)
- Issuer (mainly European banks) creates a specific pool of mortgages on its balance sheet and segregate it from other assets
- This pool is then used as collateral for issued bonds
- The underlying assets are not transferred to an SPE
- Investors receive payments from the issuer
- Pass-through securities (true securitizations)
- The pool is removed from the bank’s balance sheet and transferred to an SPE
- The SPE then issues securities backed by these pooled assets
- Investors receive payments as they are ‘passed through’ the SPE
- Payments are passed through proportionally via different tranches
- Different tranches receives different payments
- Subordination/tranching involves creating more than one class or tranche
- Bond classes are classified as senior bond classes or subordinated bond classes
- Subordinated bond classes are also known as ‘non-senior’ or ‘junior bond’ classes
- Bonds with structural enhancements
- Enhancement of predictability of payment patterns of pass-through securities due to the
redistribution of cash flows across specified tranches to a preset schedule - The set payment schedule mitigates the unexpected changes in payment patterns due to default,
prepayments, etc. - Mortgage-backed securities
- ABS backed by mortgages
- A distinction is sometimes made (commonly in the US) between
- MBS (e.g. Residential Mortgage-Backed Securities) and
- ABS backed by non-mortgage assets (e.g. Collateralized Debt Obligations)
Types of ABS
- Covered bonds (not full securitizations)
- Pass-through securities (true securitizations)
- Bonds with structural enhancements
- Mortgage-backed securities
Benefits of Securitization
Benefits to Issuers
- Loans made to customers sit on a bank’s balance sheet and are relatively illiquid
- If, however, they act as intermediaries between borrowers and investors they can improve their profitability, earn origination fees and reduce capital requirements for loans that are sold to investors
- By removing assets and lending risks from their balance sheets, banks operate more efficiently on a risk-adjusted basis
- Selling assets also generate income and, ultimately, securitization enables banks to expand lending origination beyond their balance sheet
Benefits of Securitization
Benefits to Investors
- Securitization provides a direct conduit between borrowers and investors
- Investors can tailor interest rate and credit risk exposures to suit their specific risk, return and maturity needs
- Many investors don’t have the capacity and expertise to originate, monitor and collect payments from underlying loans and receivables but they can invest in securities backed by these loans and receivables
- As an example, a pension fund with a long-term investment horizon can use these products to achieve higher returns, match asset maturities to anticipated liability payout dates as well as increasing diversity in its asset pool
- In essence, they can increase exposure to the risk-return characteristics of a wider range of underlying assets
Benefits of Securitization
Benefits to Economies and Financial Markets
- Securitization creates tradable securities with higher liquidity than the original loans
- Trading securities in the secondary market allows investors to determine equilibrium prices
- Making financial markets more efficient
- Securitization also improves overall liquidity in the financial system and reduces liquidity risk
- Securitization provides an alternative means of funding business operations
- Companies can use securitization to reduce their funding costs by pooling assets to increase their return on capital versus borrowing through traditional means
- Securitizations provide efficiencies and benefit many parties
- Manufactures can outsource debt servicing, consumers benefit from reduced costs and investors benefit from diversified investment opportunities
- Of course, it not all good news. Securitizations also bring risks
- Risks related to the timing of cash flows; i.e. contraction risk and extension risk
- The inherent credit risk of the underlying loans and receivables backing the ABSs
Parties to a Securitization
- The three main parties to a securitization are:
- The seller of the collateral (the depositor/ originator) – the company that has sold goods to its customers
- The SPE that purchases the loans or receivables from the seller and uses them as collateral to issue the ABS
- The servicer of the loans (often a financing subsidiary of the seller - responsible for the collection of payments from the borrower
- Other parties (known as third parties to a securitization) are also involved
- Accountants, lawyers, trustees, underwriters, rating agencies and possibly financial guarantors
- Apart from the regular bond indenture and its covenants, two additional documents are required
- The purchase agreement between the seller of the collateral and the SPE
- The prospectus which describes the structure of the securitization
- A trustee or trustee agent (also known as a ‘disinterested trustee’) safeguards the assets that have been sold to the SPE, holds the funds due to the ABS holders until they are paid and provides regular cash flow reports to ABS holders
The Role of the SPE
- Without an SPE, securitization would not be possible
- Securitization can be a cheaper way to raise funds because the SPE is not affected by bankruptcy of the seller of the collateral
- We say that the SPE is bankruptcy remote – the separation of the seller of the collateral and the SPE is critical
- The credit risk for investors is that borrowers of the underlying loans default on their payments
- However, it is important to note that not all countries have the same legal framework
- Impediments with respect to ABS issuance have arisen in some countries
- Investors should evaluate the legal considerations that apply in the jurisdiction where they purchase ABS
Covered bonds
- Senior debt obligations issued by financial institutions backed by a segregated pool of assets that typically consist of commercial or residential mortgages or public sector assets
- Similar to ABS but they offer bondholders dual recourse, i.e., to both
- The issuing financial institution
- The underlying asset pool
- The underlying assets are kept on the financial institution’s balance sheet and are not transferred to a bankruptcy remote SPE as happens with an ABS
- Normally only have one bond class per cover pool (no tranching)
- Unlike ABS that can have prepayment risk, cover pool sponsors must replace any prepaid or non-performing assets to ensure sufficient cash flows until maturity
- The unique features of covered bonds, including redemption regimes, mean that they usually carry lower credit risk and offer lower yields than otherwise similar ABS
Covered Bonds
Redemption regimes
- Redemption regimes exist to align the covered bond’s cash flows as closely as possible to the original maturity schedule should the bond’s financial sponsor default
- Hard-bullet covered bonds – if payments are not made as scheduled a bond default is triggered and bond payments are accelerated
- Soft-bullet covered bonds – delay the default and accelerated payments until a new final maturity date which is usually up to a year after the original maturity date
- Conditional pass-through covered bonds – convert to pass-through securities after the original maturity date if all bond payments have not been made
ABS Structures to Address Credit Risk
Credit enhancements
- Most securitization structures involve multiple tranches where each of the tranches plays a different role
- Often one tranche assumes risk from other tranche
- Securitization structures seek to mitigate credit risk through credit enhancements
- Internal credit enhancements - three main types of are widely used
- Overcollateralization
- Excess spread
- Subordination/credit tranching
- External credit enhancements:
- Financial guarantees by banks or insurance companies, letters of credit and cash collateral
ABS Structures to Address Credit Risk
Credit enhancements
* Overcollateralization
- An arrangement whereby a bond’s collateral value exceeds the face value of the issued bonds (this is very common with covered bonds)
- Even if there are defaults in the bond pool, there is a cushion to continue paying principal and interest
- This cushion makes the senior and subordinated tranches more attractive to investors
ABS Structures to Address Credit Risk
Credit enhancements
* Excess spread
- Is the difference between the coupons on the underlying collateral and the coupon paid on the bond
- If the average loan in the pool pays 7.5% and the ABS pays 6% then the excess spread can absorb collateral shortfall or can be used to build up reserves
ABS Structures to Address Credit Risk
Credit enhancements
Subordination or credit tranching
- More than one bond class/tranche is created
- Classes differ in how they share losses from the collateral pool
- Classes include senior and subordinated
- The subordinate classes are sometimes called ‘non-senior’ or ‘junior’ bond classes
- The lowest tranche is sometimes referred to as the ‘equity’ tranche
Non-Mortgage Asset-Backed Securities
Credit card receivable-backed securities
- Non-amortizing loans.
- Lock-out periods are present during which cash flows paid to bonds holders only consist of finance charges and fee collections. Once the lock-out is finished principal is no longer reinvested but paid to investors.
- Cash flows = Finance (interest) charges + Late payment and annual membership fees + Scheduled principal + Prepayments.
- Interest may be fixed or floating (typically uncapped).
- The only way principal cash flows can be altered is by exercising an early amortization provision when safeguarding of the credit-quality of the issue is required.
Non-Mortgage Asset-Backed Securities
Solar ABS
- Solar loans allow consumers to borrow the cost of purchasing the solar energy system from the installer
- Solar leases involve renting the solar equipment directly from a solar company
- Institutional investors have become interested in investing in solar ABS which are backed by solar loans and leases
- They want to contribute to sustainability
- Solar ABS can generate attractive risk-adjusted yields
- The structure of a solar ABS transaction and its collateral depend on the jurisdiction
- As well as being collateralized by solar loans and leases, solar ABS can be further collateralized by a lien placed on the installed system, on the property itself, or both
- When the solar energy system loans are structured as residential home improvement loans, the solar ABS effectively securitizes a subordinated (junior) mortgage on the home
Collateralized Debt Obligations (CDO)
Structure of a CDO
- CDO is a generic term to describe a security back by a diversified pool of one or more debt obligations:
- Collateralized bond obligation (CBO) – backed by corporate and emerging market bonds
- Collateralized loan obligation (CLO) – backed by leveraged bank loans
- Structured finance CDO – backed by RMBS, CMBS, ABS
- Synthetic CDO – backed by a portfolio of credit default swaps
CDO risks
- CDO bonds are constructed to provide a specific level of risk for investors.
- The CDO has provisions set aside to impose restrictions on the collateral manager via various tests and limits in order to meet the risk/return appetite for investors as well as providing adequate protection to the senior bond holders:
- De-leveraging provision – if tests are failed, payoff of the senior tranches occurs as a priority until the tests are satisfied
- Performance of the collateral is important for the CDO manager to be able to make payments to the bond classes.
- Cash flows = Interest from collateral assets + Maturing of collateral assets + Sale of collateral assets
- Loss to the equity tranches will occur if the returns from the collateral does not exceed the cost of paying off the senior and mezzanine tranches. The maximum loss will represent their entire investment.
Time Tranching
Prepayment risk
- Contraction risk
- If interest rates decrease, prepayments will increase since homeowners will refinance at lower rates
- The maturity of a MBS will be shorter than what was expected at the time of purchase
- Contraction risk is the risk that the borrower repays principal or a portion of it in a shorter period of time than what was expected
- Investors in the MBS will have to reinvest the proceeds at a lower rate
- The prepayment option reduces the potential price appreciation of the bond
- Extension risk
- Interest rates increase, prepayments will decrease since homeowners are less likely to refinance and may delay new home purchases
- The maturity of a MBS will be longer than what was expected at the time of purchase
- Contraction risk is the risk that the borrower repays principal or a portion of it in a longer period of time than what was expected
- Higher interest rates reduce the value of payments received
- The extension stretches out the payments that investors will receive
Time tranching
- The structure of a securitization may allow the redistribution of prepayment risk among bond classes
- An approach for reducing this risk is to create bond classes that have different maturities
- This is known as time tranching
- A securitization pool may contain sequential tranching
- Principal payments flow first to one tranche until the principal is fully paid then to the next tranche
Mortgage Loans and Their Characteristic Features
Mortgage loans
- Loan secured by collateral of real estate property obliging the borrower to make a series of payments to the lender
- Lender has the right to foreclose on the loan if the borrower defaults
- Allows the lender to take possession and sell it in order to recover funds
- Mortgage loan = Property purchase price - Down payment
- The down payment represents the borrower’s equity position
- Over time, as the market value of the property changes the borrower’s equity position changes
- The equity position also changes as the borrower makes principal payment
- Loan-to-value ratio (LTV)
- The higher the ratio the lower the borrower’s equity and less protection the lender has for recovering the amount loaned if default occurs
- Debt-to-income ratio (DTI)
Mortgage Loans and Their Characteristic Features
Prime and subprime loans
- In the US, market participants typically identify two types of mortgages
- Prime loans have borrowers of high credit quality with strong employment and credit histories
- Subprime loans have borrowers with lower credit quality, high DTI and/or are loans with higher LTV and include loans that are secured by second liens otherwise subordinated to other loans
Mortgage Loans and Their Characteristic Features
Specifications of mortgage design
- Prepayments and prepayment penalties
- Prepayment – any payment towards repaying principal in excess of the scheduled principal repayment
- Prepayment option – contractual provision for repaying in part or in full
- Prepayment penalty mortgages – monetary penalty if borrower prepays within a certain time period after loan origination
- Allowing prepayments creates uncertainty in the timing and amount of cash flows –known as prepayment risk (more detail later in the reading)
- Rights of the lender in a foreclosure
- Recourse loan – lender has a claim against the borrower for the shortfall from the loan amount and proceeds from the property sale
- Non-recourse loan – lender has no such claim and can only look to the sale of the property to recover the outstanding balance
Typical RMBS sectors
> Agency RMBS (Full guarantee by a Federal Agency,
Government Sponsored Enterprises (GSE))
> Non-agency RMBS
Agency RMBS (Full guarantee by a Federal Agency,
Government Sponsored Enterprises (GSE))
Full guarantee by a Federal Agency:
E.g. Government National Mortgage Association (Ginnie
Mae)
* Full faith and credit of the U.S. Government
Government Sponsored Enterprises:
* E.g. Federal National Mortgage Association (Fannie
Mae) and Federal Home Loan Mortgage Corporation
(Freddie Mac)
* Do not carry the full faith and credit of the U.S. Government
* Guarantee by the GSE itself
* Conforming loans – mortgage loans must meet
specific underwriting standards established by various
government agencies
Non-agency RMBS
- RMBS issued by private entities
- Not guaranteed by a federal agency or GSE
- No restrictions on the loans that can be securitized
- Non-agency RMBS will use credit enhancements to reduce credit risk
Residential Mortgage-Backed Securities (RMBS)
1. Mortgage Pass–Through Security
Cash flow characteristics
* Payments are made to bond holders each month
- Cash flow = Interest + Scheduled principal + Prepayments
* Cash flows from mortgages are reduced by servicing fees and other fees (e.g. for guaranteeing the issue) therefore the pass-through coupon rate is therefore less than the mortgage rate
* Not all the mortgages in the pool have identical characteristics:
- Weighted Average Coupon (WAC) – mortgage rate weighted by outstanding mortgage balance
* Often expressed as a range, e.g. 8.2% – 8.4%
- Weighted Average Maturity (WAM) – remaining maturity weighted by outstanding mortgage balance
– weighted average life : incorporates scheduled payments and prepayments
- do not reallocate risk
Residential Mortgage-Backed Securities (RMBS)
Conforming and non-conforming loans
- Conforming loan – meets specified criterion to be included in the loan pool of an agency RMBS. Criterion used include:
- Size of loan
- Loan documentation required
- Maximum loan-to-value ratio
- Requirement for insurance
- Non-conforming loans used as collateral for mortgage pass-through securities are privately issued
Residential Mortgage-Backed Securities (RMBS)
2. Collateralized Mortgage Obligations (CMOs)
- Securities where the cash flow of mortgage-related products are redistributed to various tranches.
- Prepayment risk (extension and contraction risk) is redistributed among the tranches through a process called structuring. Hence, the tranches created have differing levels of prepayment risk.
- This broadens the appeal of mortgage backed securities to institutional investors with different risk-return profiles
- In contrast to mortgage pass-through securities the collateral for a CMO is a pool of mortgage pass-through securities not a pool of mortgages.
Residential Mortgage-Backed Securities (RMBS)
Sequential-pay CMOs
- CMO split into tranches
- Principal repayments are made according to sequential priority
- Coupons are paid on outstanding principal
- Each class of bond paid off sequentially
Tranche, Contraction risk, Extension risk
A (seq. pay), High, Low
Tranche, Contraction risk, Extension risk
B (seq. pay),
Tranche, Contraction risk, Extension risk
C (seq. pay), low, high
Residential Mortgage-Backed Securities (RMBS)
Planned amortization class (PAC) tranches
- Amortization based on a sinking fund schedule within a range of prepayment speeds (initial PAC collar) hence creating greater predictability of cash flows for the PAC holder, i.e. reduced prepayment risk.
- The greater predictability of cash flows comes at the expense of support tranches or companion tranches.
- Most CMO PAC structures have more than one PAC tranche.
(Increasing prepayment risk)
PAC-A tranche
Supported by
PAC-B tranche
Supported by
Support tranche (contraction + extension risk high) / companion tranche
Residential Mortgage-Backed Securities (RMBS)
Support tranches
- the reduction of prepayment risk on the PAC tranches
comes at the expense of the support tranches - If prepayments are slow support tranches do not receive principal until the PAC tranches receive their scheduled principal
- This reduces extension risk to the PAC tranche
- If prepayments are fast support tranches absorb the principal in excess of the scheduled principal
- This reduces the contraction risk to the PAC tranche
Residential Mortgage-Backed Securities (RMBS)
Floating-rate (and inverse floating-rate) tranches
- Fixed-rate tranches can be further split into floating and inverse-floating tranches
- Floaters pay more when rates go up and inverse-floaters pay more when rates decrease. Therefore the two tranches offset each other
Other CMO Structures
* Z-tranches
- Z-tranches
- Do not pay interest until a pre-set date when both principal and accrued interest payments start
- During the accrual period, at each payment date, the principal value of the Z-tranche is credited by the coupon payment rate
- This benefits other tranches because it frees up cash flows that other tranches can distribute
- For the Z-tranche, a benefit is that it doesn’t suffer reinvestment risk when rates fall
Other CMO Structures
* Principal-Only (PO) securities
- Principal-Only (PO) securities
- Only scheduled principal payments and prepayments are paid out
- The value of these securities is sensitive to interest rate and prepayments rates
- When rates fall and/or prepayments increase, the value of the PO rises
Other CMO Structures
* Interest-Only (IO) securities
- Interest-Only (IO) securities
- Holders only receive interest payments from the pool
- With increased prepayments, the cash flows paid to the IO investors decline
Other CMO Structures
*Residual traches
- Residual tranches
- Collect any remaining cash flow from the pool after all the obligations to the other tranches are met
- Appropriate for hedge funds and long-term institutional investors who can assume risk and hedge it
Other CMO structures
- z-tranches
- principal-only securities
- interest only securities
- residual tranches
Commercial Mortgage-Backed Securities (CMBS)
Commercial mortgage-backed securities
- Backed by a pool of commercial loans on income-producing property such as multi-family properties (e.g. apartment buildings), office buildings, industrial properties such as warehouses, shopping centers, health care facilities and hotels
- It is common for commercial loans to be non-recourse. The lender must therefore review each property individually using measures commonly used in credit risk:
- Loan-to-value
- Debt-to-service coverage ratio = Annual net operating income / Debt service
- The higher the ratio the more able the borrower is to service the debt from the cash flows of the property
Basic CMBS structure
- Subordination is commonly used to achieve a desired credit rating for a CMBS
- Characteristics specific to CMBS include call protection and balloon maturity provisions
Commercial Mortgage-Backed Securities (CMBS)
Call protection
Call protection
* Investors have considerable call protection at the:
- Loan level
* Prepayment lockout
* Prepayment penalty points
* Yield maintenance (‘make-whole’) charge
* Defeasance – borrower provides sufficient funds for the servicer to invest in a portfolio of government securities to replicate the cash flows that would exist in the absence of prepayment
- Balloon maturity provisions
* Loans with substantial principal repayment at maturity.
* Default of this payment may result in extension of the loan over a period of time called the ‘workout period’. Often this is at a higher ‘default interest rate’.
* This risk is referred to as balloon risk (a type of extension risk).
CMBS v RMBS
Underlying assets
> From one to a pool of commercial
mortgages on income-producing
property
> A pool of mortgages backed by
residential properties or a pool
of RMBS
CMBS v RMBS
Issuer
> Lenders, commercial banks,
investment banks, or syndicates of
banks
> A government or quasigovernment entity or by a bank,
financial institution, or other
private business
CMBS v RMBS
Rate for security
> Europe: Floating rate, may be capped
US: typically fixed rate
> Either fixed or floating
CMBS v RMBS
Risk aspect: credit risk
> May be high, since the assets backing
the CMBS can be concentrated on one
mortgage
> Agency RMBS: issued and fully guaranteed by the government
Non-agency RMBS: Issued by banks, financial institutions, or
other private businesses that use credit enhancement to reduce credit risk
CMBS v RMBS
Risk aspect: prepayment risk
> Contraction risk: Low
No prepayment risk since commercial loans either do not offer a prepayment option or make it uneconomical
Extension risk: High balloon risk Many commercial loans backing CMBS are balloon
If balloon payment not made, the lender may extend the life of the loan
> Contraction risk: High
Particularly during periods of declining or persistently low interest rates
Extension risk: High
Particularly during periods of increasing or high interest rates
CMBS v RMBS
Risk aspect: default risk
> Depends on:
Security held: Pool based on few mortgages (high) or PMBS pools (lower)
Concentration of pool: Pool of few mortgages (high) vs. a diversified pool (lower)
> Aggregate risk may be lower due to diversification from many
small, uniform underlying mortgages
auto-loan receivable-backed securities
> amortizing loans
Prepayments come from sales, trade-ins, repossession and subsequent resale, insurance proceeds upon loss, early payoff or refinancing at a lower rate
All auto loan-backed securities have some form of credit enhancement
Governments do not issue
Commercial Mortgage-Backed Securities
single monthly mortality (SMM) rate
> is a monthly measure of prepayment for the mortgage pool.
conditional prepayment rate (CPR) : annualized SMM, this would indicate the percentage of the mortgage balance at the beginning of the year which is expected to be prepaid by the year end.
prepayment rate over the life of the mortgages could only be calculated at the end of the life of the mortgages, and can only be estimated based on an assumed prepayment rate.
Prepayment for the month / (balance at the start of the month – scheduled principal repayment for the month)
Modified duration Vs. Effective duration
MD : Yield duration is the sensitivity of the bond price with respect to the bond’s own yield- to- maturity.
ED: Curve duration statistic in that it measures interest rate risk in terms of a parallel shift in the benchmark yield curve.
effective duration and modified duration of an option-free bond
are identical only in the rare circumstance of an absolutely flat yield curve.
Typically, the two duration measures will differ, but the difference narrows when the yield curve is flatter, the bond’s time to maturity is shorter, and the bond is priced closer to its par value.
Which of the following statements most accurately describes supranational bonds?
A supranational bond refers to a bond issued by a supranational (multilateral) agency. Examples include bonds issued by the World Bank and the European Investment Bank (EIB). In certain cases, the supranational bond could represent the benchmark yield, where a liquid sovereign bond is not available.
unitranche debt
is a blend of secured and unsecured debt, its interest rate will generally fall in between the interest rates often demanded on secured and unsecured debt. The unitranche loan will usually be structured between senior and subordinated debt in priority ranking.
BEY basis
f=(1+z_x+y)^x+y / (1+z_y)^y−1
BEY
f=((1+z_x+y)^x+y/(1+z_y)^y))−1
Commercial paper maturity
Maturity ranges from overnight to one year with a typical issue maturing in less than three-months.
