Module 3 - Government Securities Flashcards

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1
Q

U.S. GOVERNMENT SECURITIES

A

Debt securities issued by the
government to raise capital for past indebtedness and the day-to-day functioning of the federal government. In general, U.S. government securities are considered safe, stable, and highly marketable securities.

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2
Q

The federal government has issued three major types of debt securities in the past and has recently issued a fourth one:

A

Bills, notes, bonds, and TIPS (the newest of the securities). A fifth security, STRIPS, is thought to be issued by the federal government, but it is not. A broker/dealer using Treasury notes or bonds issues it.
• Government securities used to be issued in certificate form, but today are only issued in book-entry form.
• This means that the investor does not get a piece of paper describing the issue.
• The customers receive a confirmation from the government, or broker/dealer through which the trade was executed, and the government keeps track of the name of the person who owns the securities.

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3
Q

Treasury Bills

A
  • TREASURY BILLS (T-BILLS) have maturities of no more than one year and are currently sold as 4-, 13-, 26-week, and 52-week maturity instruments. These are also known as 1-month, 3-month, 6-month, and 1-year Treasury bills. Note that the U.S. government does not issue 9- month T-bills.
    Because of their short maturity, T-bills react more quickly to changes in other short-term debt instruments such as repurchase agreements, banker’s acceptances, and negotiable CDs; therefore, they are considered to be more volatile than longer-term debt issues
  • Treasury bills are sold by the DEPARTMENT OF THE TREASURY (the DOT) at the direction of the FEDERAL OPEN MARKET COMMITTEE (FOMC). The FOMC is made of members of the Federal Reserve Board. The T-bills are sold at a discounted purchase price, which translates into a “yield” to the investor. Bills are not quoted in dollars, but on an annualized discounted yield to maturity basis, commonly called BASIS. This means that they have no stated interest rate but are purchased at a discount and mature at face value.
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4
Q

When are Treasury Bills Sold

A

Treasury bills are sold at a weekly auction on Mondays and Tuesdays and settle on the Thursday of the same week provided it is not a holiday. If it is a holiday, they settle on Friday, but generally this happens only once or twice a year.

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5
Q

Since 1998 the awarding of all Treasury issues is as a single-priced offering — all buyers pay the same price and get the same yield. Noncompetitive buyers receive their Treasury bills at the highest yield, the same as the competitive bidders. This is known as a single-priced auction.

A

Remember for Test

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6
Q

Treasury Notes

A

TREASURY NOTES are securities sold with a maturity from 1-10 years. They are actually issued with of 2-, 3-, 5-, 7-, and 10-year maturities, but for test purposes, the answer is 1-10 years. Notes are issued in minimum denominations of $1,000, but are usually sold in $5,000 increments up to $1 million. They are issued at a fixed rate of interest that is paid semiannually.

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7
Q

Treasury Bonds

A

TREASURY BONDS or T-BONDS are sold with a maturity of 30 years. Similar to Treasury notes, these securities are issued in minimum denominations of $1,000, and are usually sold in $5,000 denominations up to $1 million. They are issued with a fixed rate of interest that is paid semiannually. The interest on U.S. government bonds is computed by using the actual number of days in a month based on a 365-day year. They may be CALLABLE, but they must have a call date in addition to the maturity date. Not all Treasury bonds are callable, though. Callable means the right of the Treasury to redeem outstanding bonds before their scheduled maturity. This way the Treasury Department may refinance its debt if interest rates fall.

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8
Q

Treasury Inflation-Protected Securities

A

TREASURY INFLATION-PROTECTED SECURITIES (TIPS) were first introduced by the U.S. Treasury in 1997 as a variable rate government security. TIPS are the newest of the securities issued by the U.S. government

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9
Q

TIPS are characterized as follows:

A

• The interest rate is set at the time the TIPS is issued and remains the same until maturity.
• The principal amount of the TIPS is adjusted for inflation and/ or deflation, but never below the par amount.
• The value of the principal at maturity is the amount that will be paid, even if it is more than the original amount paid.
• The semiannual interest payments are based on the inflation-
adjusted principal at the time the interest is paid, and when the interest rate is applied to the adjusted principal value, the amount of the payment increases.
• The inflation rate is based on the Consumer Price Index (CPI).
• At maturity, the securities will be redeemed at the greater of their
inflation-adjusted principal or par amount at original issue.

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10
Q

Treasury Strips

A

TREASURY STRIPS or ZERO-COUPON securities are thought to be issued by the federal government, but are actually issued by broker/dealers and backed by U.S. government securities. Treasury
STRIPS are also known as TREASURY RECEIPTS.
• CATS, TIGRS, and LIONS are some well-known STRIPS
from the past.
• STRIPS is an abbreviation for Separate Trading of Registered
Interest and Principal Securities. These are notes or bonds, issued by broker/dealers and some banks that have had the interest component separated from the principal component of the investment.
– A financial institution or broker/dealer will purchase the bond or note and “strip” the interest from the principal for separate trading. The bond or note is sold at a discount, with the discount equal to the interest that would have been paid on the bond.
– The interest payments are traded separately, so a 10-year Treasury note will be converted into 21 separate securities, representing the semiannual interest payment and the final payment of the principal of the note.
• The principal of the note or bond is then resold as a ZERO- COUPON debt security, and does not make any periodic interest payments.
– Instead, the appreciation becomes the interest and is realized
by the investor upon maturity at face value. The difference between the discount price and the face value of the bond is the amount of interest that is paid to the investor.
• The interest that has been stripped off is also resold as a zero- coupon security with maturities on each of the interest payment dates.
– The investors holding the STRIPS that correspond to the
respective interest payment dates are paid at the same time as the interest is paid by the government to the holder of the original Treasury securities.
– The appreciation becomes the interest and is realized by the investor upon maturity of the STRIPS at face value.
• The amount of the discount for the STRIPS must be amortized (averaged) over the life of the bond and claimed as income on each year’s tax return during the time the bond is held, just as if the interest had been received each year.
– At the time of maturity, the holder receives the face value, but only has to pay taxes on the final year’s interest, rather than paying them on the total appreciation of the bond.
The STRIPS, or zero-coupon bonds, may be a suitable investment for a minor’s college fund, because the bond interest is taxed at the minor’s income tax rate. Additionally, a zero-coupon bond may be suitable for an IRA account, because the interest will not have to be reported each year.

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11
Q

Government Treasury securities have the following maturities:

A
  • Treasury bills — known as T-bills, have maturities of 1 month, 3 months, 6 months, and 1 year. These securities are actually issued as 4- week, 13-week, 26-week, and 52-week maturities
  • Treasury notes — issued for 1-10 years, though most are
  • issued with maturities of 2, 3, 5, 7, and 10 years. Treasury bonds — issued for 30 years
  • **To remember the order of their maturities, remember the phrase: “BILLS NOT BONDS” for “bills,” “notes,” and “bonds.”
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12
Q

The operation of the U.S. government is supported by financial obligations that are completely guaranteed. When the federal government issues Treasury bills, notes, or bonds, it guarantees the principal and interest of these securities. They are backed by the “full faith and credit” of the U.S. government.

A

Remember for Test

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13
Q

GUARANTEED DEBT

A

Guaranteed debt means that the securities (bonds) are guaranteed by the full faith and credit of the U.S. government.

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14
Q

Below are a handful of the agencies and corporations that issue guaranteed debt.

A
  • EXPORT-IMPORT BANK (EXIMBANK): The securities from this agency are used for financing trade between the United States and foreign countries.
  • SMALL BUSINESS ADMINISTRATION: This agency provides loans and management assistance to small businesses.
  • GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA): Also known as GINNIE MAE
    **GNMA is an agency under the jurisdiction of the U.S. government.
    **GNMA issues PASS-THROUGH CERTIFICATES (types of bonds) that represent a pool of mortgages, including mortgages from the Department of Veterans Affairs and from the Federal Housing Administration. (The GNMA is guaranteed, but the mortgages that are included in the GNMA are not guaranteed by the government.)
    GNMA bonds are issued with interest that is comparable to the loans that are pooled, except that the GNMA bond is issued at a yield that is 50 basis-points less than the pooled mortgages as a guaranty and service fee. Remember that basis equals yield to maturity.
    **They are issued in $25,000 minimum quantities.
    The investor receives monthly payments of interest and principal based on their ownership of the securities. Therefore, they are commonly known as MONTHLY PASS- THROUGHS.
    **The receipt of payments from borrowers of mortgage loans affects the principal and interest that is paid to the investor. A portion of the principal is paid down each month by borrowers, and refinancing of mortgages affects the amount of interest being paid to investors.
    **When people buy these securities in the secondary market, they do not have to pay the full $25,000 principal. Instead, they pay a percentage of the $25,000 face value, depending on how much has been paid in prepayments and in the monthly payments.
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15
Q

The federal government does not guarantee the debt of the following agencies:

A
  • FEDERAL HOUSING ADMINISTRATION (FHA) LOANS: These loans are guaranteed by the Federal Housing Administration, not the government, and are specifically allocated for low-income housing and first time homebuyers.
  • FEDERAL HOME LOAN BANKS (FHLB): This agency issues debt securities that provide money to savings and loans, which lend to homebuyers, small business, rural development, and agriculture.
  • FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA): This agency began as a government-sponsored enterprise and is now a private corporation with stock that trades on the NYSE.
    • FNMA issues bonds to finance the Department of Veterans Affairs, FHA, and conventional mortgage loans.
    • FNMA is commonly called FANNIE MAE.
  • FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC), or Freddie Mac: This is a stockholder corporation that provides funds for mortgage lenders. The corporation purchases mortgages that collateralize mortgage-backed securities.
  • FEDERAL LAND BANKS issue farm loans, mainly long-term loans. BANK FOR COOPERATIVES issues loans to farmers’ co-ops.
  • FEDERAL INTERMEDIATE CREDIT banks issue short-term farm loans.
  • FARM CREDIT SYSTEM (formerly known as the Federal Farm Credit Consolidated System-Wide Bank)
    • This is a system of banks composed of the last three banks discussed above: the Federal Land Bank, the Bank for Cooperatives, and the Federal Intermediate Credit Bank.
    • These banks issue equity securities for their own use and expansion.
    • They are not backed by the government, although some people feel the government would jump in and help if many farmers began having trouble, much like the government did with the savings and loans in the 1980s.
    • The Farm Credit System issues mortgage securities and discount notes and bonds for farm loans that are an obligation of all member banks in the Farm Credit System, but are ultimately backed by the mortgages on the farms and ranches.
  • STUDENT LOAN MARKETING ASSOCIATION (SLMA), or SALLIE MAE, generates debt securities used to fund the SLMA loans to students for higher education. SLMA began as a government- sponsored enterprise and is now a private corporation. SLMA is a publicly owned company whose stock trades on the NYSE. SLMA issues debt securities, such as discount notes, long-term bonds, and zero-coupon bonds.
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16
Q

The government’s long-term marketable and non-marketable debt is subject to purchasing power risk (today’s dollar versus the dollar 10 or 20 years from now when they mature) because of their length of time to maturity. Purchasing power risk is also associated with inflation. If goods cost more in the future, the same amount of dollars will purchase less.


A

Remember for Test

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17
Q

Obligations of U.S. marketable and non-marketable debt:

A

• MARKETABLE DEBT means an issue that may be traded in the
open market. Investors can purchase T-bills, T-notes, and T-bonds
or sell these securities through broker/dealers.
• NON-MARKETABLE DEBT means an issue that may only be
bought from, or redeemed by, the government (e.g., Series EE bonds).

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18
Q

MARKETABLE DEBT SECURITIES

A
  • Marketable debt securities are initially sold at auction. The auction allows
    for noncompetitive and competitive bids to be submitted by prospective purchasers.
  • The Department of the Treasury (DOT) sets the minimum amount of bid at $1 million, but an unlimited maximum amount can be bid.
19
Q

The QUOTES ON BONDS AND NOTES are expressed as a percentage of par:
• As the price goes up, the yield goes down.
• As the price goes down, the yield goes up.

A

Remember for Test

20
Q

The BID PRICE

A

The price at which the broker/dealer’s firm purchases the government bonds from the client.

21
Q

The ASK (or OFFER) PRICE

A

The price at which the firm sells the bonds to another customer. The difference is what the firm makes on buying and then selling, much like a used car salesman. The bid is the low blue book price and the ask/offer is the high blue book price.

22
Q

Think of the bid and ask prices in this manner:

A

• BID — When you have something for sale, you want to sell to
the highest bidder. Holders of stocks, T-bills, bonds, and other securities also want to sell at the highest possible price, so they sell at the “bid price” or “bid,” which is a price set by the broker/dealer’s firm based on current market conditions.
• ASK/OFFER — When you are going to buy something, you might say, “How much are you asking for that?” Similarly, when investors buy securities, they pay the asking/offer price, which is set by the broker/dealer’s firm based on current market conditions.

23
Q

All government-issued bonds and notes trade in 1/32 of a point; T-bills trade in basis points.
• A bond that is quoted at 96.12–96.20 would have a bid price of 96 12/32 and an offer price of 96 20/32.
• This means the bid is offered at 96 12/32% of par, and the offer is listed as 96 20/32% of par.
• Translated into dollars and cents, the bid is at 96.375% of par and the offer is at 96.625% of par.
• Translated into the actual price per bond, this would be $963.75 bid, $966.25 offered since the bonds are $1,000 bonds, not $100 bonds. We have to move the decimal one place to the right.
***When buying government securities, the bonds, notes, and bills must be paid for the next business day, or the settlement date.

A

Remember for Test

24
Q

Taxation of Interest

A

Interest from the securities issued by the government is subject to federal tax but is exempt from state and local taxes.
The interest on Government National Mortgage Association (GNMA
or Ginnie Mae) securities is subject to both federal and state taxes. This is the only exception to the nondual taxation rule that is generally applied to government- or government agency-issued securities.
Bonds issued by territories and protectorates are referred to as TRIPLE EXEMPT — their interest is exempt from federal, state, and local taxes. To remember who taxes which bonds, remember: “He who issues the bond, taxes the interest on the bond.”
Debt securities issued by the following are also exempt from state and local taxes:
• Farm Credit System, including:
− The FICB
− The Land Bank
− The Bank for Co-ops
• Debt securities issued by the Federal Home Loan Bank are also exempt from state and local taxes.

25
Q

To remember who taxes which bonds, remember: “He who issues the bond, taxes the interest on the bond.”

A

Remember for Test

26
Q

DETERMINING ACCRUED INTEREST

A

The interest on U.S. government bonds and notes is calculated on the number of days elapsed and a 365-day year when determining the amount of days of accrued interest. The test requires you to calculate the days of accrued interest.
Use the following shortcut to calculate the number of days of accrued interest. First, begin with the formula:
SETTLEMENT DATE
- LAST INTEREST DATE
= NUMBER OF MONTHS AND DAYS OF ACCRUED INTEREST
Then, assuming that every month has 30 days, add one day for every month with 31 days and subtract two days if February is in the interest period because it only has 28 days. This will help you to include the actual days.

27
Q

MONEY MARKET INSTRUMENTS

A

Debt securities that mature in one year or less. Government securities are considered high-grade, meaning low-risk. Since these securities are short-term, they are sought for short- term money use. The two types of money market instruments that are U.S. government securities are:
• Treasury bills, or T-bills, discussed above
• Federal Funds

28
Q

FEDERAL FUNDS

A

Monies on deposit at the Federal Reserve Bank. These funds are deposited by:
• Individuals purchasing U.S. government securities at the auction as noncompetitive purchasers
• Banks, broker/dealers, and others who are purchasing U.S. government securities at the auction as primary dealers
• Broker/dealers when clearing trades in U.S. government securities
– Only trades in U.S. government securities clear through the Federal Reserve System in fed funds. Municipal bonds and all corporate stock and bonds clear trades through clearing houses.
Banks with funds in excess of the reserve requirement as mandated by the Federal Reserve System for member banks.
– When banks have more reserves than they need, they lend these funds (known as federal funds) out to other banks, to theFed, to broker/dealers, or even to corporations.
– Overnight federal funds are very short-term, very safe, and never change hands. It is all BOOK-ENTRY, meaning just shown on the books of each entity involved in the transaction.

29
Q

The FEDERAL FUNDS RATE

A

The rate a bank charges for use of its excess federal funds, enabling the borrower to use the money, usually overnight, to meet a money shortage.
• The federal funds rate is usually known as the OVERNIGHT LENDING RATE from one bank to another and is considered the most volatile interest rate. This rate changes daily, as the Federal Reserve Board (FRB or the Fed) directs, through the open market operations of the Federal Open Market Committee (FOMC). The banks need to keep a percentage of their deposits in reserve, determined by the FRB, and to do this they can borrow from the FRB or borrow from each other. The FRB does not want the banks to constantly borrow from the Federal Reserve System. If a bank continues to do so, the FRB refuses the loans and/or goes in and inspects the bank more closely to see why the bank is letting its reserves fall so low. For this reason, the banks loan to each other through the use of federal funds.
• The federal funds rate is usually determined by noon Pacific Time, or at the latest by 2 p.m. each day. As this time nears, the banks determine the amount of reserves they will need. Banks that need money determine from whom they will borrow, thus determining the rate at which they are borrowing. The rate that the banks borrow from each other will be in the range as set by the FOMC.

30
Q

Other money market instruments that are not government-issued include:

A
  • Commercial paper
  • Banker’s acceptances
  • Project notes
31
Q

BROKER LOANS

A

Also known as CALL LOANS, because
brokerage firms use them to finance loans for margin purchases by their customers.
• Commercial banks provide the funds for the customer’s purchases, but require the underlying stock as collateral.
• The stock has to be registered in the name of the brokerage firm, which means that it has to be in street name, with the firm listed as the registered owner, and with the customer as the beneficial owner.
• BROKER CALL RATE is the interest rate that is charged by the bank to the broker/dealer for borrowing the money. This interest rate is closely related to interest rates of other types of money market instruments.

32
Q

COLLATERALIZED MORTGAGE OBLIGATIONS (CMOs)

A

The latest of the high-grade debt securities issued in the debt market by broker/dealers.
• All CMOs, including GNMA, FNMA, Freddie Mac, Plain Vanilla, PAC, and TAC CMO’s are composed of 15-, 20-, 25-, and 30-year home loans.

33
Q

CMOs are issued in TRANCHES

A

• A tranche is the term used to describe the “LIFE
EXPECTANCIES” (maturities) of a bond issue backed by one or
more GNMA, FNMA, or other mortgage-backed debt issues.
• Most mortgage-backed debt, such as GNMA, represents a pool of
mortgages from different banks with different borrowers.
• As a result, the mortgage backed debt issues are backed by the
numerous mortgages on the real property. They are usually secured by deeds of trusts, or mortgage paper, on the underlying properties.
• At the time the CMO is issued, each tranche will have its own interest and maturity.
• The interest is called the WEIGHTED AVERAGE COUPON (WAC) and is produced by the interest from the mortgages on the underlying property.
• The maturity is called the WEIGHTED AVERAGE MATURITY (WAM) and is generated from the average duration of the mortgages on the property.
• Both the WAC and the WAM must be calculated separately.

34
Q

PREPAYMENT SPEED ASSUMPTIONS

A
  • The PSA is a benchmark of assumed principal payment speeds as determined by past prepayments for home loans.
  • The amount of the prepayments and the rate at which the prepayments are paid vary according to the interest of the loans that are held and the new interest rates that are being offered.
  • At the time the amount for each tranche is determined, present interest rates and expected future interest rates are taken into consideration in figuring the amounts that are expected to be paid in any one year.
  • The PSA is this benchmark that the originators of the tranches assume will be the amounts to be paid back each year.
35
Q

The tranches are issued in increments of $1,000, compared with GNMA and FNMA securities, which are issued in increments of $25,000.
• Like the underlying security, tranches pay interest on either a monthly, quarterly, or semiannual basis. Most CMOs pay monthly.
As interest rates in the outside market fall, the prepayments on CMOs and their companion tranches increase. As interest rates rise, prepayments decrease or are nonexistent.

A

Remember for Test

36
Q

Risk in CMOs

A

• Since CMOs are backed by a pool of mortgages, the risk of
unpaid repayment should be lessened.
• If backed by government agency issues (GNMA), this backing
may be indicated.
• Remember that the interest and principal are not guaranteed
by the U.S. government. If the CMO is backed by a GNMA, the underlying securities, not the payments, are guaranteed by the government.
• If the CMO is not backed by a GNMA, then it is backed by the issuer of the underlying securities.
• Guarantees of yield, maturity, and market value cannot be made because these may vary widely from one tranche to another.

37
Q

PLAIN VANILLA CMOS

A

Plain Vanilla CMOs are the original CMO securities. These are usually created by broker/dealers who have purchased a pool of mortgages or a pool of pass-through securities (such as a GNMA) for their account, and then split them up into tranches.
• A trustee holds the pool of mortgages or pass-throughs as collateral for the tranches.
• The creator of the CMO separates the principal and interest according to how they will be received and sets them up as tranches.
• The shorter tranches are established for the early principal payments, and the later-maturing mortgages continue until paid. The later-maturing mortgages represent the later interest and principal payments.
• Each year, people pay principal and interest on their properties. Sometimes, they make excess principal payments, which then go toward paying off additional principal in the other tranches. Other times, less principal is paid, meaning that some of that year’s tranches will not be paid off, and their due dates will be extended. Regardless of the amount of principal paid each year, the interest on all tranches will be paid. For this reason, the following is true:
– All principal payments are paid sequentially. The tranches maturing in early years are paid with the first principal payments, and subsequent payments are applied to the tranches in the order they are due. (Remember, tranches do not “mature”; they are “due to be paid.”)
– The interest payments are distributed to each tranche according to that tranche’s interest rate.
• Early payoffs of the principal are usually applied to the earliest tranche, then sequentially to the later ones.
• By separating the cash flows from the pool of mortgages, investors can get a wide variety of maturing mortgages with some reduction in prepayment risk.
• This is done by creating the numerous tranches, each having its own Weighted Average Coupon (WAC) and Weighted Average Maturity (WAM)
• The drawback of the plain vanilla CMO is that the investor has to be concerned with possible early calls or having the principal payment amount extended.

38
Q

PAC AND TAC TRANCHES

A

Planned Amortization Class (PAC) and Targeted Amortization Class
(TAC) tranches are similar to the Plain Vanilla CMOs, but they differ in a number of ways:
• PAC and TAC tranches have companion securities associated with them. The companion securities act as a buffer against excessive prepayments of principal according to the PSA schedule.
• When excess principal is paid, the excess goes to the prepayment companion securities of the next earliest maturity years rather than to the main tranche of the PAC or TAC. This makes the tranche (the main tranche) maturity more of a certainty.
• The extension-risk companion securities accompany the PAC CMOs only, and act as a buffer against unexpected lack of principal payments, thus reducing the risk of late payments to the PAC main tranches. However, the extension-risk companion securities could have increased risk and uncertainty as a result of these payment provisions. Therefore, the average life of the extension-risk companion securities varies, while the main tranche of the PAC will have greater certainty of cash flow.
• The TAC CMO, however, does not have the extension-risk companion securities, and therefore the main tranche of the TAC has the same uncertainty as the extension-risk companion securities of the PAC CMO.
• The prepayment companion securities’ average life is shortened when interest rates go down. This is true because homeowners are more likely to refinance when interest rates go down, and prepayments will go up.
• The extension-risk companion securities’ average life is extended when interest rates go up. This is true because homeowners are less likely to refinance when interest rates go up, and prepayments will go down.
• With a greater chance for early calls, companion securities have higher yields than original PACs or TACs. This is because of the increased risk; if the companion securities are called, holders will not gain the higher yields associated with the risk.

39
Q

The difference between a PAC tranche and a TAC tranche is:

A

• A PAC CMO has a main tranche and two companion
securities — one for early payments of principal by the borrowers, or prepayments, and one for extension-risk, payments that are late due to mortgage holders who are not refinancing or paying off mortgages as expected.
• The TAC CMO has a main tranche and only one companion security — the prepayment companion security; therefore, the TAC tranche has a greater chance of being retired late than the PAC.

40
Q

An investor in either the PAC or the TAC CMO has the choice of investing in the main tranche, investing in one of the companion securities, or spreading the investment dollars into a combination of one of the tranches and one or more companion securities. The main
tranche will give the investor a greater chance of payment on time. The investment in one of the companion securities would have the risk of either being called early (purchasing prepayment companion securities) or having their payment period extended (extension-risk companion securities).
• A person who purchases a PAC tranche has greater certainty of being paid at the end of the tranche period.
• A person who purchases a TAC tranche has greater extension risk, but has protection against early calls.
• A person who purchases a companion security of either the PAC or the TAC may not be paid on time; rather, they may be paid early (prepayment companion) or have the pay-off period extended (extension-risk companion)

A

Remember for Test

41
Q

The following is a comparison of CMOs and regular bonds:

A

• Regular government, corporate, and municipal bonds are issued at face value. These bonds pay interest semiannually, and the return
of principal is at maturity.
• Plain Vanilla CMOs, as well as PACs and TACs, are issued like a
bond, at face value, and also pay interest yearly; however, the interest payment may be monthly, quarterly, or semiannually. The principal on the tranche may or may not be paid on the expiration date.
• With the prepayment uncertainty of certain CMOs and the extension of payment on most CMOs, the investment return may vary widely, depending on the type of CMO, whether the person invests in the main tranche or a companion tranche, and how the interest rates change.

42
Q

CMOs are more often quoted in terms of their “average life” rather than their stated maturity date. The average life is the average time that each principal dollar in the pool is expected to be outstanding, based on certain assumptions about prepayment speeds.

A

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43
Q

CMO tranches have four main classes: A, B, C, and Z tranches. Some CMOs have a fifth tranche, the Y tranche. The A, B, and C tranches receive interest monthly or semiannually, and the principal when due. The Z (and Y) tranche do not receive anything until the other classes are paid off. Many people refer to the Z tranche as the “zero-coupon” tranche, because it is similar in many ways to a zero-coupon bond. A zero-coupon bond receives nothing until maturity, but a Z tranche does not receive interest or principal until after the A, B, and C tranches are paid their interest and principal. The Z tranche is the last tranche to be paid and is very much like a zero-coupon bond.

A

Remember for Test