Volume 4 - Fixed Income Flashcards
Fixed-Income Features:
describe the features of a fixed-income security
describe the contents of a bond indenture and contrast affirmative and negative covenants
Fixed-Income Cash Flows and Types:
describe common cash flow structures of fixed-income instruments and contrast cash flow contingency provisions that benefit issuers and investors
describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities
Fixed-Income Issuance and Trading:
describe fixed-income market segments and their issuer and investor participants
describe types of fixed-income indexes
compare primary and secondary fixed-income markets to equity markets
The two main categories of fixed-income instruments are loans and bonds. Loans are private lending contracts, typically between a company and a financial intermediary (e.g., banks). Bonds, also known as fixed-income securities, are issued to and traded by investors.
Issuer:
1. The government and government-related sector:
Supranational organizations
Sovereign (national) governments
Non-sovereign (local) governments
Quasi-government entities
- The private sector:
Corporations
Special purpose entities that issue asset-backed securities
A debt security’s tenor is the time remaining to maturity. For example, a 10-year bond issued 2 years ago has an 8-year tenor. The existence of a maturity date makes debt a temporary source of capital.
Fixed-income instruments with maturities of less than one year are known as money market securities, while those with longer maturities are called capital market securities. Although relatively uncommon, perpetual bonds have no stated maturity.
Perpetual bonds differ from equity because they have contractual cash flows, greater seniority, and no voting rights.
Amortizing bond:
However, other debt instruments (e.g., mortgages), the principal is repaid incrementally as part of the periodic payments rather than as a single lump sum. Bond prices are often quoted as a percentage of par value.
Floating-rate notes (FRNs) have coupon rates that change based on the performance of a market reference rate (MRR) with a spread that reflects the issuer’s creditworthiness.
Contingency Provisions :
Bonds may include contingency provisions, such as embedded call options that allow the issuer to buy back its debt from lenders at a pre-determined price. An embedded put option grants lenders the right to force issuers to repurchase their debt. Another common contingency provision allows investors to convert their debt securities into a fixed number of common shares.
A basic yield measure is the current yield, which is simply the bond’s annual coupon divided by its current price. Another much more commonly-used yield measure is yield to maturity (YTM). This is the internal rate of return that makes the present value of a bond’s future cash flows equal to its current price.
An investor who purchases a bond today at its current price will earn the YTM as an annualized rate of return if the following conditions are met:
- The issuer makes all interest and principal payments as scheduled
- All payments received before maturity are reinvested to earn the YTM
- The bond is purchased today at its current market price and holding it until maturity or sold on the constant yield price trajectory
A government yield curve can be created from the yields on instruments ranging from 1 month to 30 years. A corporate issuer’s yield curve for the same maturities will almost certainly plot above the government yield curve, reflecting the market’s assessment of credit risk.
The curve forms from bonds yields that:
- Are from the same issuer
- Have the same features
At Premium: Price > Par –> Coupon > Yield
Bond Indenture:
The trust deed (or bond indenture) describes the obligations of the bond issuer and the rights of the bondholders. It specifies the principal value, coupon rate, maturity date, covenants, contingency provisions, collateral, credit enhancements and sources of repayment.
The indenture is held by a trustee, he is appointed by the issuer but acts in a fiduciary capacity for bondholders and his duties are mainly administrative (e.g., maintaining records) (unless a default occurs).
The most creditworthy corporate borrowers are typically able to issue unsecured bonds that are backed only by the issuer’s operating cash flows. Investors may require issuers with lower credit quality to issue secured bonds that are backed by collateral, such as liens (claims) on specific assets.
Covenants are legally enforceable contract terms, which may be either affirmative (positive) or negative in nature.
Affirmative covenants are usually administrative in nature, such as commitments to provide regular financial reports to lenders. A pari passu (or “equal footing”) clause ensures that all creditors within the same seniority class are treated equally. Another common affirmative covenant is a cross-default clause, which deems a borrower to be in default on all of its debt obligations if it defaults on any of its issues.
In order words, it prescribes what issuers are required to do.
Negative covenants typically restrict the issuer in areas such as additional debt issuance. A commitment to refrain from issuing new debt with a higher seniority is known as a negative pledge clause. A prohibition on breaching specific levels of certain leverage or solvency ratios is known as an incurrence test.
Fixed-income securities are most commonly structured as bullet bonds, with coupon payments paid at regular intervals and the full face value repaid at maturity.
A fully amortized loan provides equal annuity-like payments that are split between interest and principal. Over time, the interest portion decreases and the principal portion increases. Credit risk decreases as the borrower’s liability is reduced with each payment.
A partially amortized bond amortizes some principal in each of its periodic payments. A balloon payment is made at maturity for any portion of the face value that has was not amortized over the term of the loan, but this is less than the bullet payment that is due when a conventional bond matures.
In a sinking funds arrangement, periodic payments do not include any principal but the borrower agrees to deposit funds into an escrow account according to a schedule. These funds can then be used to return a portion of the bond’s principal prior to maturity.
From the perspective of investors, a sinking fund reduces exposure to credit risk in the same way as amortization, but it creates potential exposure to reinvestment risk if they are required to redeem their bonds early.
A waterfall structure creates multiple classes of investors with different priority claims. This type of tranching is commonly used for mortgage-backed securities.
Bonds with coupon rates linked to an external index are called floating-rate notes (FRNs). Attractive to investors who expect interest rates to rise, although they are exposed to the risk that rates will fall.
Coupon payments on variable rate instruments may be predetermined. Step-up bonds pay coupons that increase periodically based on a set schedule, offeringprotection against rising interest rates and give issuers an incentive to repurchase (call) bonds if interest rates remain stable or fall. This structure is often used for leveraged loans to issuers with relatively low credit quality.
Payment-in-kind (PIK) bonds allow the issuer to pay coupons with more bonds rather than cash. This is an attractive funding option for companies that are uncertain about their future cash flows. Expectation of higher yields (increased credit risk.)
1000 at 10% year 1 : No 10% coupon –> instead increase to 1100 the FV
It is also possible to make a bond’s coupon rate contingent on the occurrence of specific events. Sustainability-linked bonds are a recent innovation that pays a stepped up coupon rate if the issuer fails to meet the environmental performance targets listed in the indenture.
Credit-linked notes have coupon rates that are tied to the issuer’s credit ratings. The coupon rate will increase if the issuer gets downgraded and decrease if the issuer gets upgraded.
Indexed-linked bonds pay coupons based on a rate that is tied to a specific index.
Interest-indexed bonds are structurally equivalent to FRNs because they make a fixed principal repayment but their coupons are adjusted based on a reference rate of inflation.
Capital-indexed bonds pay a fixed coupon rate that is applied to a principal amount that is adjusted for inflation.
A zero-coupon bond is called a pure discount bond because no coupons are paid.
Deferred coupon bonds, also called split coupon bonds, pay no coupons in the early years and then higher coupons in later years. This structure allows issuers to defer cash payments while investors can potentially defer their tax liability.
Zero coupon are technically an extreme split bond. which explains why these securities are typically priced at a discount to their par value.
A bond’s indenture may contain contingency provisions that specify actions that may be taken under certain conditions.
If a company issues a 10-year, 5% coupon bond, and investors subsequently only require a 4% yield, the company will be paying an above-market rate on its borrowed funds. If the bonds included a call option, the company could repurchase its outstanding debt and issue new debt at a lower interest rate. If the market yield rises above 5%, the company can simply choose not the exercise its call option.
Callable bonds often specify a call protection period during which the issuer is not permitted to exercise its call option. After the call protection period has expired, the issuer has the right to repurchase the bonds at a call price schedule that is outlined in the indenture.
Callable bonds may include a make-whole provision that compensates lenders with a lump-sum payment based on the present value of coupon payments that will not be received if the call option is exercised. If borrowers offer such a provision, lenders will be willing to accept a lower call premium.
A Bermuda-style put option gives investors multiple opportunities to sell their bonds back, while a European-style put option provides just one.
Bondholders benefit from the opportunity to redeem their bonds if market rates rise or if the issuer’s credit quality declines. In exchange for this protection, investors are willing to accept lower yields or pay a higher price on putable bonds compared to otherwise equivalent option-free bonds.
Conversion parity exists if the conversion premium is zero. If the convertible bond price is greater than the conversion value, there is a positive conversion premium and the conversion condition is described as below parity. If the convertible bond price is less than the conversion value, the conversion premium is negative and the conversion condition is above parity.
Most investors do not exercise their conversion option until maturity, even if the issuer’s share price has risen above the conversion price. This is because the interest payments on convertible bonds are generally higher than any dividend payments that would be made to common shareholders.
issuers often put a call option that grants them the right to force a conversion if their stock price rises above a specified level.
Warrants are like a conversion option in the sense that they allow the holder to purchase common shares at a specific price. However, they are often offered as “sweeteners” to reduce borrowing costs rather than being structured as embedded options. Warrants may be traded separately on public equity exchanges.
Contingent convertible bonds (CoCos) are issued by financial institutions. The bonds automatically convert to equity if a certain trigger is reached (e.g., the issuer’s capitalization ratio falls below the regulatory minimum level). Lenders have no control over the timing of exercise and they are exposed to downside risk, so yields are relatively high compared to otherwise equivalent bonds.
Bonds are considered domestic if issued by an entity incorporated in that country. Foreign bonds are issued outside a company’s domestic market.
Eurobonds are traded on the Eurobond market and are typically less regulated because they are beyond the jurisdiction of any single country. Eurobonds are named after the currency in which they are denominated. For example, Euroyen bonds are denominated in Japanese yen.
usually unsecured bonds underwritten by a consortium of financial institutions known as a syndicate.
most Eurobonds have been bearer bonds, meaning that only the clearing system knows who owns the bonds.
Global bonds are simultaneously issued in the Eurobond market and at least one domestic market.
Some bonds, such as those issued by local governments in the United States, may be tax-exempt.
When a bond has been issued at a discount, investors must consider the taxable status of the difference between the bond’s issue price and its face value. Depending on the jurisdiction, this original issue discount (OID) may be deemed to include a portion of the accrued interest as interest income. For example, US investors are taxed annually on the prorated portion of the discount as interest income. By contrast, Japan treats the entire discount as a capital gain to be taxed once at maturity.
Two of the most important factors affecting fixed-income investment decisions are maturity and credit quality.
maturity spectrum:
Short-term: Less than one year
Intermediate-Term: 1 to 10 years
Long-term: Greater than 10 years
Credit categories:
Default risk free: Developed market sovereign issuers, typically rated AAA
Investment grade: Corporate issuers rated BBB- or higher
High Yield: Corporate issuers rated BB+ or lower
The rate of return expected by bond investors is inversely related to the issuer’s credit quality.
Some institutional investors have constraints against holding bonds that are rated below investment grade. These investors may be forced to liquidate their positions in bonds issued by fallen angels, which is the term used to describe issues that were originally given an investment grade rating but have subsequently been downgraded below BBB-.
Differences between indexes that make it more challenging to replicate the performance of bond indexes:
1- While corporate issuers may have one or two classes of common stock, they can have dozens of different types of fixed-income securities outstanding. As a result, some bond indexes have over 10,000 components.
2- Unlike equity securities, bonds have a finite life. Bond indexes need to be rebalanced and reconstituted relatively frequently (e.g., monthly) to replace components that are nearing maturity.
3- Similar to equity indexes that are weighted based on market capitalization, bond indexes are typically weighted according to the market value of debt outstanding. Bond indexes must adapt as different types of issuers or issues become a larger or smaller share of the market. Additionally, bond market indexes tend to give significant weight to government securities, which are often the largest and most actively traded bonds.
Represent feature (maturity, coupon structure, industry sector, and the issuer’s ESG rating.)
Like stocks sold for the first time in an initial public offering, bonds are first sold to investors in the primary markets.
Repeat bond issuers regularly issue follow-on offerings in the primary market to replace maturing issues. A follow-on offering’s coupon rate is typically different from the rate on the issue that is being replaced. This reflects continually changing market conditions and perceptions of the issuer’s creditworthiness.
Replacement of maturing bonds is much more common than a reopening, which increases the size of an issuer’s existing bond trading at a price that is significantly different than its par value. Frequent issuers take advantage of shelf registrations, which allow them to offer a range of bonds through a single, all-compassing offering circular that is updated regularly over time.
Often only qulified institutional investors
Public offerings are usually done via underwritten offerings, best-effort offerings, and auctions. Underwritten offerings (also called firm commitment offerings) are underwritten by an investment bank, which agrees to purchase any bonds that cannot be sold to investors. By contrast, in a best-efforts offering, the investment bank’s involvement is limited to acting as a broker. Sovereign debt is typically issued in the primary market via auctions.
Because investors are less familiar with high-yield issuers, these issues take longer to complete than unsecured investment-grade bond issues. Investors require more time to consider the types of covenants and collateral that they require. Issuances of high-yield bonds are typically done on a best-efforts basis. Smaller issuers seeking more complex, customized lending terms will likely need to negotiate an unregistered, non-underwritten private placement with a small group of qualified investors.
Bonds are traded among institutional investors and central banks in secondary markets.
Most bond trading is still done in quote-driven over-the-counter (OTC) markets. Institutional investors, financial intermediaries, and central banks are all active participants in secondary bond markets.
The bid-offer spread (bid-ask spread) represents the difference between the prices at which a dealer will buy and sell a bond. A low bid-ask spread indicates a liquid market. On-the-run sovereign bonds often have bid-ask spreads of less than a single basis point. while dealers typically quote spreads of at least 10 basis points for more seasoned corporate bonds.
Distress debt issues of companies that are near or already in bankruptcy generally trade at prices that reflect the expected recovery rate.
Distressed debt securities will continue to be traded in OTC secondary bond markets even after the issuer’s common shares have been removed from exchanges for failing to meet the listing requirements.
Fixed-Income Markets for Corporate Issuers:
compare short-term funding alternatives available to corporations and financial institutions
describe repurchase agreements (repos), their uses, and their benefits and risks
contrast the long-term funding of investment-grade versus high-yield corporate issuers
Fixed-Income Markets for Government Issuers:
describe funding choices by sovereign and non-sovereign governments, quasi-government entities, and supranational agencies
contrast the issuance and trading of government and corporate fixed-income instruments
External Loan Financing:
Loan financing is provided by financial intermediaries (e.g., banks). Common short-loan term financing instruments include lines of credit, secured loans, and factoring.
Lines of Credit:
Uncommitted Lines of Credit: With this facility, a company can borrow up to a specified amount for a pre-determined maximum maturity. There is no cost other than interest charges on borrowed amounts. However, this is an unreliable source of financing, as it may be recalled by the bank at any time. For banks, the capital requirements associated with these facilities are minimal until they are drawn upon by borrowers.
Committed Lines of Credit: This is a more reliable source of financing than uncommitted lines of credit because of the bank’s formal commitment. They are also known as regular lines of credit. They are unsecured and pre-payable without penalty. The term is usually 364 days, less than a full year. The rate is negociable, but the most common money market rate is a benchmark reference rate plus a spread. The spread depends on the borrower’s creditworthiness. There’s also a commitement fee which may be 0.5% of the full or unused amount.
Revolving Credit Agreements: Also known as revolvers, these are the most reliable source of financing. They involve formal legal agreements. (similar to commited but involves multiple-year term (e.g., terms of 3 to 5 years) and much larger amounts)
Secured Loans and Factoring:
Secured (Asset-Based) Loans: These are loans in which the company is required by the lender to provide collateral in the form of an asset. A lien is filed against them by the lender, and the lien subsequently shows up on the borrower’s financial record. The collateral can help a company reduce the interest rate because it makes the loan safer for the lender.
Companies that do not qualify for unsecured loans due to their credit quality can make arrangements for secured loans to raise short-term funds. For example, accounts receivable can be used to produce cash flows (responsability of collecting payments from their customers.)
Factoring: A factoring arrangement allows companies to sell their accounts receivable to a lending and collection specialist, known as a factor. Effectively, a company is outsourcing its credit granting and collection process to the factor. These sales provide a company with cash immediately but they often occur at a significant discount, which represents the cost of this source of funding. The extent of the discount is determined by considerations such as the credit quality of the accounts as well as expected collection costs.
External, Security-Based Financing:
Larger, more creditworthy firms can often reduce their borrowing costs by issuing debt in financial markets. For these issuers, commercial paper (CP) is the main instrument used to raise short-term funds.
Firms typically issue CP with maturities of less than three months and roll them over as they mature. This practice gives companies the financial flexibility to fund working capital requirement and meet seasonal demand for cash. It can also serve as a source of bridge financing to meet longer-term needs until more permanent sources of capital can be secured.
Maturing obligations are typically repaid with the proceeds generated from issuing more CP. This practice, known as rolling over, exposes issuers to the risk borrowing costs will have increased in response to market conditions. –> Protection : issuers have a committed backup line of credit that will provide sufficient funds to retire maturing obligations if new CP cannot be issued.
United States commercial paper (USCP) is denominated in US dollars and represents the largest segment of the CP market. Eurocommercial paper (ECP) is similar to USCP in many ways but it is issued in the international market. Despite its name, ECP may be denominated in any currency, including the US dollar. The ECP segment of the CP market is generally characterized by less liquidity and smaller transaction sizes than the USCP segment.
Deposits:
Bank’s main source of funding (from individuals and commercial clients).
Banks typically pay little to no interest on on funds that are kept in checking accounts, which are known as demand deposits because they can be withdrawn at any time. Demand deposits are an unattractive source of funding because the lack of a stated maturity makes them a relatively unstable. Banks also generate operational deposits by providing clearing, custody, and cash management services for larger clients (more stable source).
Savings deposits are an even more stable source of financing because they have a defined maturity. Banks offer certificates of deposit (CDs) that pay a specified interest rate over a period of up to one year. CDs may be negotiable or non-negotiable. A non-negotiable CD cannot be sold by the depositor and a penalty is charged on early withdrawals. A negotiable CDs can be sold on the Eurobond market prior to maturity (small for retail clients and large for institutional investors).
Interbank market lending may be done on a secured or unsecured basis, with repurchase agreements being the most common form of secured loans (from overnight to one year and rate typically tied to a market reference rate + compensation for credit risk).
The central bank funds rate is the policy rate that a central bank uses to pursue its macroeconomic objectives and in its open market operations. This also is the rate that a central bank pays to commercial banks on their reserve deposits. Commercial banks that are unable to raise sufficient funds in the interbank market may, as a last resort, borrow from the central bank’s discount window.
Asset-Backed Commercial Paper:
Banks and other intermediaries also use a secured form of CP, known as asset-backed commercial paper (ABCP), as a low-cost source of short-term financing.
The SPE then issues securities to investors, who receive the right to the interest and principal payments on the loans that the bank made to its customers. In order to enhance the SPE’s liquidity, the bank provides it with a back-up credit facility.
Benefits:
Banks : off-balance-sheet financing provides cash without creating a liability, + undrawn backup liquidity for the SPE reduces the bank’s cost of capital compared to holding the short-term loans to maturity.
Investors: gain exposure to an asset class (private loans) that they would not be able to access without this kind of securitization.
Repurchase agreements, or repos, are important sources of secured financing. In a repo agreement, one party “sells” a security for a purchase price and agrees to buy it (or a similar security) back later at a higher amount. Difference between the purchase and repurchase prices is determined by the repo rate.
The “seller” remains the legal owner of the security and receives any interest payments that they make during the term of the agreement. From the lender’s perspective, it can be described as reverse repurchase agreement or reverse repo.
A standard master repurchase agreement can be used as a template for negotiations. In practice, repos typically have very short terms and collateral tends to be high quality securities and normally a maturity of one-day (overnight), longer maturities are called term repos.
An initial margin of 100% means that the purchase price is equal to the security price. In other words, the loan is fully collateralized. If the initial margin is greater than 100%, so the amount of the loan (purchase price) is less than the value of the collateral (security price), it is overcollaterized (haircut).
A variation margin is used to adjust the amount of collateral based on the change in the security price between initiation at time = 0 and time = t.
If the security price falls, the variation margin will be positive and the borrower will be required to deposit additional collateral. By contrast, if the security price rises and the variation margin is negative, the borrower can request the release of this amount of collateral.
Factors Influencing Repo Rates
For a general collateral repo, a group of securities is identified and any can be used as collateral. This type of transaction takes place at the general collateral repo rate. A repo transaction that involves the delivery of a particular security, known as a special trade, occurs at a special collateral repo rate that deviates from the baseline general repo rate. When a particular security is subject to very high borrowing demand, this special repo rate may fall below the general collateral repo rate or even below zero. Under a negative repo rate, the security buyer pays interest on cash lent to the cash borrower.
Key factors influencing repo rates include:
Money market interest rates: Repo rates are lower if alternative financing rates are low. For example, repo rates are correlated with target policy rates because central banks participate in repo markets to influence the money supply.
Collateral quality: Repo rates increase with the collateral’s credit risk.
Repo term: Repo rates generally increase with the length of the term because the yield curve is typically upward sloping and a longer term increases exposure to credit risk.
Collateral uniqueness: Repo rates are lower when the collateral used is in high demand, such as on-the-run issues of sovereign bonds.
Collateral delivery: Repo rates are lower when delivery to the lender is required or if the loan is overcollateralized.
Risks Associated with Repurchase Agreements:
Default risk: For parties to a repo, the primary concern is that their counterparty will fail to meet its obligations.
Collateral risk: Ideal collateral has little to no correlation with the counterparty and can be quickly liquidated in the event of a default.
Margining risk: Timely variation margin transfers minimize the risk of shortfalls and forced liquidations in the event of a significant change in market value of collateral.
Legal risk: Counterparties should have access to courts in order the event that they need to enforce their contractual rights under the repo agreement.
Netting and settlement risk: Payments and collateral transfers should be timely and leave all parties with the amounts that they are owed under the terms of the contract.
Triparty Agents : . In order to mitigate exposure to various risks, participants can choose to involve a third party administrator to take responsibility for cash management, valuation, and custodial services.
However, the terms of repo agreements are very short (usually overnight), which creates exposure to rollover and liquidity risk. During periods of market turmoil, such as the 2008 financial crisis, the sudden illiquidity of credit markets has led to significant losses for large financial institutions that were heavily reliant on repo agreements as a source of financing.
While short-term funding sources are well-suited to finance current assets such as working capital, long-term debt is more appropriate for financing fixed-assets and capital investments.
Investment Grade:
The largest proportion of an investment grade bond’s yield-to-maturity is attributable to the government yield for the same maturity, with credit spread accounting for a relatively small share (few covenants or restrictions). Rollover risk is minimized by issuing bonds of various tenors and limiting the amount of maturing debt that must be replaced at any given time.
High-Yield Bonds:
Credit spreads account for a larger proportion of yields. Because of the greater likelihood of default, high-yield debt tends to be analyzed as an equity-like instrument with a minimum value determined by the probability of default and recovery rate and the potential for significant capital gains. (more restrictive covenants)
Covenants will restrict acces when lower borrowing costs. (Renegociation)
To reduce their borrowing costs and maintain greater financial flexibility, companies can choose to issue leveraged loans with prepayment features or callable debt that can be repurchased at a specified price above par. High-yield issuers are more likely to do this if management is confident that the company’s creditworthiness will improve.
Fallen angels : These are firms that enjoyed investment grade credit ratings at the time of issue but have subsequently been downgraded to high-yield status.
Some constraints against holding high-yield debt and would be forced to sell any debt issued by fallen angels when they are downgraded. This dynamic typically leads to significant price deterioration because relatively few investors are willing to accept the additional risk associated with high-yield debt.
A corporate issuer of commercial paper would most likely use a backup line of credit to mitigate:
A
credit risk.
B
rollover risk.
C
currency risk.
B
All else equal, which of the following factors would most likely reduce the repo rate for a repurchase agreement?
A
Lengthening the maturity
B
Using widely-available collateral
C
Requiring physical delivery of collateral
C
Sovereign issuers are national governments that administer a country’s public goods and services and have the legal authority to levy taxes and fees on economic activity within their jurisdiction (central bank). However, issues from quasi-government agencies and local governments are treated as a separate segment of the bond market (unless they carry a government guarantee, effectively making them sovereign issues).
Governments issue debt to balance their accounts when they operate fiscal deficits.
In contrast to domestic debts, external debt obligations are owed to foreigners. In order to attract investors from beyond their borders, emerging market governments are often required to issue debt obligations denominated in more widely-traded foreign currencies such as the euro or the US dollar. This eliminates direct currency risk exposure for foreign investors, but they remain exposed to indirect currency risk if the emerging market issuer is unable to convert its illiquid domestic currency into the currency in which its debts are denominated.
According to the Ricardian equivalence theorem, developed by economist David Ricardo, government debt management policies are irrelevant if the following conditions hold:
- Taxpayers save expected future taxes in order to smooth their consumption
- Taxpayers believe any current tax cuts will lead to future tax increases
- Taxpayers can borrow freely in perfectly efficient capital markets with no transaction costs
- Taxpayers will pass along any accumulated tax savings to their heirs
Under these conditions, the present value of a government’s future tax cash flows will be unaffected by its debt maturity choices. The implication is that governments should be indifferent between collecting taxes today or issuing debt, regardless of its maturity.
(This in real life is false)
Assumptions related to capital market efficiency leads to the conclusion that governments should choose debt management policies based on the liquidity preferences. Because investors require a liquidity premium on longer-dated bonds, governments can minimize their borrowing costs by issuing debt with the shortest possible maturity (but brings roll over risk). Budgets and tax rates would become highly sensitive to interest rate fluctuations.
In practice, governments manage their borrowing costs and rollover risk exposure by spreading their debt obligations across a range of maturities at regular intervals.
Economic benefits when governments debts is across the maturity spectrum:
The creation of a benchmark yield curve with risk-free rates for key maturities improves the efficiency of domestic capital markets
Financial institutions use medium- and long-term government securities to manage their interest rate risk exposure
Using government securities as collateral for repo transactions reduces the cost of this form of borrowing
Trading government bonds is an important monetary policy implementation tool for central banks
Government bonds are an ideal vehicle for foreign currency reserves
Sovereign debt is typically issued through public auctions that are run by the country’s Treasury or Finance Ministry. Prior to the auction date, investors must submit bids indicating the number of securities that they wish to purchase. Bids may be competitive or non-competitive, with competitive bidders having to specify the maximum price that they are willing to pay and non-competitive bidders agreeing to accept the price that is determined by the auction.
Once bids have been received, all non-competitive bids are accepted and competitive bids are ranked by price to determine how to allocate the bonds that have not already be designated for non-competitive bids as well as the price (or prices) that will be paid. Then, starting with the highest price (lowest required yield) and moving down to the lowest price (highest required yield), competitive bids are accepted until the entire issue has been allocated.
In a single-price auction, all selected bids (both competitive and non-competitive) pay the same price. The price or coupon rate generated by a single-price auction is determined by the stop yield, which is the yield on the lowest price competitive bid that is accepted. If the process is structured as a multiple-price auction, each competitive bidder that is accepted pays the price that they have bid.
In general, a multi-price auction structure produces larger bid sizes with a narrower range of prices. By contrast, a single-price auction incentivize a wider distribution of bids and tends to result in lower borrowing costs. There also is evidence to suggest that the single-price structure is more successful in allocating entire issues.
Sovereign governments identify primary dealers, which are large financial intermediaries that are required to participate in all competitive auctions and may serve as counterparties for the central bank’s open market operations.
Off-the-run securities from previous issues are comparatively illiquid–> On the run are more liquid (more recent and more traded)
Certain bond market participants use government securities to pursue “non-economic” objectives. For example, central banks use domestic government bonds to implement monetary policy and foreign governments use sovereign issues as currency reserves. Regulated institutions such as insurers and banks may hold more government bonds than they otherwise would in order to meet capital adequacy requirements. This activity reduces borrowing costs for sovereign issuers, particularly countries with a reserve currency, such as the United States (low yields)
Government agencies include quasi-government entities with a legal mandate to provide specific public goods or services (e.g., airport authorities). These organizations access debt markets to raise funds for their short-term working capital requirements and long-term investments, with debt issues typically structured to match the duration of the associated activity.
They have the ability to rely on their sovereign government sponsors as a secondary source of repayment.
By having this backing, they can borrow to near the same yields as sovereigns
General obligation bonds issued by non-sovereign governments are unsecured debts that are backed by local tax revenues. Alternatively, local and regional governments can issue revenue bonds are issued to fund a specific project, such as a road or a stadium, and backed by the revenues that it generates (long maturity)
Supernational organizations like the World Bank and International Monetary Fund are created to pursue mandates such as economic development or trade promotion. These organizations are typically able to rely on the sovereign governments of their member countries to fund their activities, but they also access debt markets to raise funds.
With this backing, they are able to borrow at lower rates than emerging market country governments would be able to on their own. And by issuing in major currencies, they are able to reduce (but not eliminate) currency risk exposure for global bond market investors.
Governments have been motivated to issue floating-rate debt in response to investor demand for sovereign bonds that carry less interest rate risk than the fixed-rate debt that is most commonly issued by governments.
Although interest rate risk is reduced for investors, it is not completely eliminated.
the lower a coupon on a bond, the higher its sensibility to changes in rates
the higher a coupon on a bond, the lower its sensibility to changes in rates
Coupon effect
Longer the Tenor of the bond, the greater change of price for a change in yield
Maturity Effect
EXECPTION!!:
Low yield, long term bonds at a discount
Fixed-Income Bond Valuation: Prices and Yields:
calculate a bond’s price given a yield-to-maturity on or between coupon dates
identify the relationships among a bond’s price, coupon rate, maturity, and yield-to-maturity
describe matrix pricing
Yield and Yield Spread Measures for Fixed-Rate Bonds:
calculate annual yield on a bond for varying compounding periods in a year
compare, calculate, and interpret yield and yield spread measures for fixed-rate bond
Yield and Yield Spread Measures for Floating-Rate Bonds
The candidate should be able to:
calculate and interpret yield spread measures for floating-rate instruments
calculate and interpret yield measures for money market instruments
The Term Structure of Interest Rates: Spot, Par, and Forward Curves
The candidate should be able to:
define spot rates and the spot curve, and calculate the price of a bond using spot rates
define par and forward rates, and calculate par rates, forward rates from spot rates, spot rates from forward rates, and the price of a bond using forward rates
compare the spot curve, par curve, and forward curve
discount at the market discount rate (also known as the required yield or required rate of return).
A bond’s yield-to-maturity (YTM) is the discount rate that makes the present value of its expected future cash flows equal to its current price. In other words, it is the single discount rate that is implied by a bond’s observed price.
YTM is a promised yield because it is the internal rate of return (IRR) that an investor would earn if the following assumptions hold:
The bond is purchased today at its current market price and holding it until maturity
All cash flows (coupons and principal) are received on the scheduled dates
All coupon payments received prior to maturity are reinvested to earn the YTM
When a bond is sold between coupon payments, the next coupon payment must be allocated between the buyer and seller. (Accrued interest that is due to the seller)
Accrued interest calculations are also affected by the day count convention that is used. The 30/360 day-count convention assumes that there are exactly 30 days in each month and 360 days per year. By contrast, the actual/actual day count convention uses the exact number of days in each period.
Note that accrued interest is purely a function of time. It is unaffected by any changes in the bond’s yield.
A bond’s full price (also known as its invoice price or dirty price) can be calculated by its present value on the last coupon payment date adjusted for the portion of the current coupon period that has passed.
The amount of interest that has accrued to the seller since the last coupon payment is included in a bond’s full price. However, accrued interest is excluded from a bond’s flat price (or clean price).
Bond market dealers typically quote flat prices because a bond’s full price reflects increases in accrued interest due purely to the passage of time. However, a buyer pays the full price on the settlement date in order to compensate the seller for the portion of the next coupon payment that they have accrued but will not be receiving.
Convexity effect: All else equal, the percentage increase in a bond’s price caused by a lower yield will be greater in magnitude than the percentage decrease caused by an equivalent increase in its yield.
Coupon effect: Bonds with lower coupon rates experience a greater percentage price change for a given change in the market discount rate than otherwise equivalent bonds with higher coupon rates. All else equal, a zero-coupon bond is more sensitive to changes in interest rates than a coupon-paying bond.
Maturity effect: As a general rule, longer-term bonds experience a greater percentage price change for a given change in the market discount rate. The maturity effect holds for both zero-coupon bonds and bonds that are trading at or above par. However, exceptions to this rule can be observed among low-coupon, long-term bonds trading at a deep discount.
Constant-Yield Price Trajectory: Assuming no change in the yield curve, bonds that are trading at a discount or a premium will be “pulled to par” as they approach maturity. Consider the example of two 3-year annual coupon bonds: Bond A pays 7% and Bond B pays 3%. Assuming a 5% discount rate, Bond A will be issued at a price of 105.45 per 100 par. At the end of one year, its price will fall to 103.72. One year after that, the price will fall to 101.94. By contrast, Bond B’s price will be 94.55 initially before rising to 96.28 after one year and 98.10 after two years as it is pulled to its par value.
To properly compare yields on bonds with different periodicities, it is necessary to use the effective annual rate measure. This is an annualized and compounded measure with a periodicity of 1. It assumes that interest can be reinvested at the periodic rate.
The current yield is the sum of the coupon payments received over a year divided by the flat price. While simple to calculate, this yield measure ignores the frequency of coupon payments and any accrued interest. It also ignores the gain or loss from purchasing a bond at a discount or premium.
The simple yield is a less crude measure that includes an adjustment for the amortization of gains or losses on a straight-line basis.
The street convention yield assumes that a bond’s cash flows will occur on the scheduled dates, even if those happen to occur on a weekend or a holiday. A bond’s true yield uses the actual date the cash flow will be made, such as the Monday following a weekend. Whenever there is a discrepancy between a bond’s street convention yield and its true yield, the street convention yield will be higher but the difference is typically negligible.
Both the street convention yield and the true yield are calculated on the assumption of 30 days per month and 360 days per year, as is standard market practice for corporate bond quotes. The government equivalent yield restates a bond’s yield-to-maturity based on the actual/actual day count convention.
Yield-to-call is the internal rate of return assuming the bond is called early at the stated call price.
It is possible to calculate measures such as yield-to-first-call, yield-to-second-call, etc. The lowest yield among these is called the yield-to-worst.
While the yield-to-worst measure is commonly quoted in practice, a more precise measure to use for bonds with embedded options is the option-adjusted yield. This measure is calculated using a bond’s option-adjusted price, which is calculated as the price of an equivalent option-free bond less the estimated value of the embedded call option.
The benchmark rate is often the yield on a comparable government bond. The benchmark yield will capture the top-down macroeconomic factors that affect all bonds. The benchmark rate is composed of the expected real risk-free rate plus the expected inflation rate.
The other component that is common to all bonds and the bond-specific is the spread (risk premium) that reflects bottom-up microeconomic factors and compensates investors for taxation, liquidity, and credit risk.
The following spread measures can be calculated relative to a benchmark rate:
1- The benchmark spread is the difference between a bond’s yield and a specific benchmark yield.
2- The G-spread is the difference between a bond’s yield and an actual or interpolated government bond yield.
3- The I-spread (or interpolated spread) is the difference between a bond’s yield and the swap rate or a similar market refence rate (MRR) for the same tenor. It can be interpreted as the relative cost of structuring a debt issue as a fixed-rate bond rather than a floating-rate obligation. The I-spread indicates a bond’s credit risk relative to the MRR index.
The G-spread and I-spread approaches use the same discount rate for each cash flow. To fine tune the calculation, a Z-spread can be used, which is the spread over the spot curve.
The Z-spread can also be used to calculate the option-adjusted spread (OAS) on a callable bond.
The quoted margin (QM) is the spread that the floating-rate issuer pays over the reference rate to compensate investors for accepting the issuer’s credit risk. The QM is set at the time an FRN is issued and it remains fixed over its life. It It is possible for the most creditworthy companies to issue FRNs with a negative quoted margin.
The discount margin (DM) (or required margin) is the yield spread over the reference rate needed to make the FRN trade at par at a coupon reset date. It is the market’s assessment of the spread that is consistent with the issuer’s current credit risk. The DM will change and deviate from the QM as new information becomes available.
If the issuer’s credit quality deteriorates, the DM will increase and the FRN will trade below its par value, reflecting the face that the QM being paid is no longer sufficient compensation for the issuer’s current credit risk. Conversely, the DM will fall and the FRN will trade above its par value if the issuer’s credit quality improves.
Even if the DM remains at the same level as the QM, the FRN will trade at a premium to par between coupon dates if the MRR falls (or it will trade at a discount to par if the MRR rises). However, these types of deviations are temporary and the FRN will be pulled back to it par value as the coupon reset date approaches assuming that the DM continues to match the QM.
There are key differences between the money market and the bond market:
- Yield measures for money market instruments are stated in annualized terms with simple (uncompounded) interest. By contrast, bond market yields are both annualized and compounded.
- While bond market quotes are are standardized to a common periodicity for all maturities, quotes for money market instruments of different maturities use annual rates with different periodicities.
- Unlike bond market yields, which can be calculated using standard time value of money formulas, money market instrument yield quotes are often based on nonstandard interest rates and require the use of different pricing methods.
Usually, commercial paper, Treasury bills, and bankers’ acceptances are quoted on a discount rate (DR) basis.
Bank certificates of deposit and repos are quoted on an add-on rate (AOR) basis.
When comparing money market securities, it is important to use consistent methods. This is often done using a bond equivalent yield, which is a 365-day add-on rate basis.
A par rate represents the coupon rate for that makes a government security of a given duration trade at par. The par curve can be derived from the spot curve.
Forward Rates: The notation can be confusing, but normally the first number is the length of the forward period and the second number is the tenor of the underlying bond. For example, the “3y5y” is the five-year yield three years into the future. A forward curve is a series of forward rates, each having the same time frame.
Interest Rate Risk and Return
The candidate should be able to:
calculate and interpret the sources of return from investing in a fixed-rate bond;
describe the relationships among a bond’s holding period return, its Macaulay duration, and the investment horizon;
define, calculate, and interpret Macaulay duration.
Yield-Based Bond Duration Measures and Properties
The candidate should be able to:
define, calculate, and interpret modified duration, money duration, and the price value of a basis point (PVBP)
explain how a bond’s maturity, coupon, and yield level affect its interest rate risk
Yield-Based Convexity and Portfolio Properties
The candidate should be able to:
calculate and interpret convexity and describe the convexity adjustment
calculate the percentage price change of a bond for a specified change in yield, given the bond’s duration and convexity
calculate portfolio duration and convexity and explain the limitations of these measures
Curve-Based and Empirical Fixed-Income Risk Measures
The candidate should be able to:
explain why effective duration and effective convexity are the most appropriate measures of interest rate risk for bonds with embedded options
calculate the percentage price change of a bond for a specified change in benchmark yield, given the bond’s effective duration and convexity
define key rate duration and describe its use to measure price sensitivity of fixed-income instruments to benchmark yield curve changes
describe the difference between empirical duration and analytical duration
The sources of return from a bond investment are:
1- Receipt of coupon payments and principal on scheduled dates
2- Reinvestment of coupon payments (“interest on interest”)
3- Capital gains or losses
The total rate of return that an investor will earn from all sources on a fixed-rate bond investment will match the bond’s yield-to-maturity (YTM) under the following conditions:
1- All cash flows are received as scheduled
2- Coupons are reinvested at the YTM
3- The bond is either held to maturity or sold on the constant yield price trajectory
The total return is the sum of reinvested coupon payments and the sale price (if the bond is sold before maturity) or redemption amount (if the bond is held to maturity).
Reinvestment risk is a greater concern for for investors with longer investment horizons. Investors who intend to hold a bond until maturity have no exposure to price risk during the bond’s lifetime because, assuming no default, they will receive the bond’s par value at maturity regardless of how much its price fluctuates during its lifetime. However, if the bond matures prior to the investor’s time horizon, the will be risk associated with reinvesting the principal repayment at maturity. By contrast, investors with shorter investment horizons are more sensitive to price risk.
Reinvestment risk is greater for bonds with higher coupon rates.
When an investor’s horizon exceeds the bond’s Macaulay duration, reinvestment risk dominates price risk. This is described as “negative reinvestment risk” because the investor risks having to reinvest coupons at a lower rate. In the opposite scenario (i.e., Macaulay duration is greater than investment horizon), price risk dominates reinvestment risk and the investor faces “negative price risk” because the bond’s price will fall if interest rates rise.
The Macaulay duration measure, named after Canadian economist Frederick Macaulay, is the weighted average life of the cash flows, with the weights being the present value of the cash flows. Macaulay duration is important to considerations of the tradeoff between reinvestment risk and price risk because it represents the investment horizon that is immune to interest rate changes. In other words, if a bond’s Macaulay duration is equal to an investor’s holding period, any losses in reinvestment income from a one-time parallel decrease in yield will be matched by capital gains due to price appreciation (and vice versa for a decrease in yield).
A bond’s duration measures its sensitivity to changes in interest rate changes. However, there are several duration statistics, which fall into two categories:
Yield duration measures the sensitivity of a bond’s price to its own YTM. Statistics in this category include Macaulay duration, modified duration, money duration, and the price value of a basis point (PVBP).
Curve duration measures sensitivity to changes in a benchmark yield curve, such as spot rates for zero-coupon government bonds of various maturities. Effective duration is the most commonly used curve duration statistic.
Macaulay duration > Investment horizon:
Positive duration gap
Price risk dominates
Exposure to rising interest rates
Macaulay duration < Investment horizon:
Negative duration gap
Reinvestment risk dominates
Exposure to falling interest rates
Modified duration can be used to estimate the percentage change in a bond’s full price (flat price plus accrued interest) for a given change in its YTM
Both Macaulay duration and modified duration can be converted into annual terms by diving by the number of coupon periods per year. For example, if a semiannual coupon bond has a modified duration statistic of 8 on a per period basis, its annual modified duration is 4.
It is important to note that estimated price changes based on modified duration are linear approximations. Modified duration estimates will understate the sensitivity of a bond’s price to changes in its YTM.
An approximation of the modified duration measure can be directly calculated by estimating the slope of the tangent to the price-yield curve. Shifting the yield up and down by a certain percentage generates two new price estimates (PV- and PV+).
Money Duration
While the modified duration statistic measures the sensitivity of a bond’s price in percentage terms, money duration expresses this change in terms of currency units (Dollar duration –> USA).
Price Value of a Basis Point
The price value of a basis point (PVBP, or PV01) is a variation of money duration that estimates the currency value of the price change for a 1 basis point change in yield. This measure is useful for bonds with uncertain cash flows, such as callable bonds.
Related to the price value of a basis point is basis point value, which is the product of money duration and a single basis point (0.01%, or 0.0001)
Yield Duration of a Zero-Coupon and Perpetual Bonds
Zero-coupon bond: Because a zero-coupon bond provides only one cash flow, its Macaulay duration is equal to its time-to-maturity. Like other bonds, a zero-coupon bond’s modified duration is calculated as its Macaulay duration divided by 1 plus its yield-to-maturity.
Perpetual bond: A bond with no maturity date and no embedded call option pays a fixed coupon each period forever. Its Macaulay duration is constant over time and is calculated as (1+ r) / r
Duration of Floating-Rate Notes and Loans
Because a floating-rate note’s coupons are periodically reset based on an underlying market reference rate, investors are only exposed to interest rate risk during the intervals between reset dates. The Macaulay duration of a floating-rate note is (T-t) / t. Wehere T is the total number of days between coupon dates and t is the number of days that have passed since the last coupon date.
Highest at middle
Compared to an option-free, fixed-rate security, a floating-rate note most likely carries:
A
less interest rate risk in any interest rate environment.
B
less interest rate risk only when interest rates are rising.
C
greater interest rate risk in any interest rate environment.
A : Interest rate risk is defined as the risk that a bond’s value will be affected by fluctuating interest rates. Because their coupon rates are periodically reset to prevailing market rates, floating-rate notes (FRNs) carry minimal interest rate risk. As a result, FRNs typically trade close to their par value. Although prices of FRNs may change in response to a change in the credit quality of their issuer, these securities carry less interest rate risk than plain vanilla fixed-rate securities in any interest rate environment.
Holding all else constant, duration has the following relationships with key bond features:
Coupon rate (Inverse): A lower coupon rate leads to a higher duration, while a higher coupon rate reduces sensitivity to changes in yield. Zero coupon bonds have higher durations that otherwise equivalent coupon-paying bonds.
Yield-to-maturity (Inverse): A higher discount rate reduces the weighted-average time to receipt of future cash flows, resulting in a lower duration. Conversely, a lower YTM (like a lower coupon rate) extends a bond’s duration by increasing the weight of a bond’s balloon payment at maturity.
Time-to-maturity (Direct): In almost all cases, coupon-paying bonds have Macaulay durations that are directly related to maturities. An exception exists with long-term discount bonds, as shown in the diagram below. Higher coupon rates or higher yields-to-maturity reduce the duration.
A bond’s convexity is the sum of the convexity of each of its cash flows
Note that a bond that pays coupons more than once annually requires a different adjustment to convert convexity into annualized terms.
An option-free fixed-rate bond will always exhibit positive convexity and, all else equal, its convexity will be higher if it has:
a longer time to maturity
a lower coupon rate
a lower yield-to-maturity, and
more dispersed cash flows
Bond Risk and Return Using Duration and Convexity
Money convexity is the quantified second-order effect of a change in yield in currency terms. It is calculated in the same way as money duration.
The two currency-based measures can be used to estimate the impact of an interest rate shift on a bond’s price
Bond portfolio’s sensitivity to interest rates can be measured: The theoretically correct method of calculating these measures is based on the aggregated time to receipt of each of the portfolio’s cash flows. A more practical alternative is to simply approximate a portfolio’s duration and convexity as the weighted averages of its bonds. This approximation will be more accurate if bonds have similar yields and if the yield curve is relatively flat.
Dose not take into account the possibility of a change in its shape (e.g., steepening, flattening, twist).
Yield-based measures of duration and convexity are based on the assumption that all of a bond’s expected future cash flows will occur as scheduled. This assumption cannot be applied for bonds that contain embedded options. Curve-based sensitivity measures estimate the impact of a change in a benchmark par curve, such as the government par rate curve.
smaller estimated changes in the benchmark curve
Effective duration is a curve duration statistic that measures the sensitivity of the bond price relative to the benchmark yield.
The effective duration measure implicitly assumes that there is no change in a bond’s credit spread. It is possible to use the effective duration measure for an option-free bond, but it this will be deviate from its modified duration unless the yield curve is flat. Effective duration must be used for any fixed-income securities that have uncertain cash flows.
Effective convexity measures the second-order effects of changes in the benchmark yield curve.
Effective duration and effective convexity can be used to estimate the impact of a change in the benchmark curve in the same way that the modified duration and convexity measures are used to estimate how a bond’s price will be affected by a change in its yield.
The callable bond behaves similarly to the option-free bond in higher interest rate environments, but it exhibits negative convexity when interest rates are low because it is more likely to be called, and any increase in its price from falling rates will be limited. The price of a callable bond is equal to the price of the straight bond less the value of the embedded option, so this negative convexity is a reflection of the fact that the option is becoming more valuable to the issuer, who has the opportunity to issue new debt at a lower rate.
The putable bond’s convexity is positive in all interest rate environments, but it is highest when interest rates are high and the put option is likely to be exercised. A put option is valuable to investors, so the putable bond’s price is equal to the sum of the option-free bond and the value of the embedded put option.
A callable bond’s effective duration falls significantly when interest rates fall and the likelihood of exercise increase. Similarly, the effective duration of a putable falls as interest rates increase.
Option can only reduce the time until cash flows are received.
The potential for non-parallel shifts in the yield curve is called shaping risk and the impact of these types of changes can be analyzed with key rate duration measures that isolate the impact of changes in specific rates : Partial duration
A bond’s effective duration can be calculated as the sum of its key rate durations.
All the duration measures introduced earlier in this reading are known as analytical duration estimates. They are calculated using mathematical formulas and assume that changes in bond prices are solely due to changes in benchmark yield. Another measure of a bond’s sensitivity to interest rates is the empirical duration, which uses historical data in statistical models to estimate the changes in bond prices under different interest rate environments. Empirical duration considers multiple factors, such as credit risk, when predicting the sensitivity of a bond’s price to changes in interest rates.
Cs of Credit Analysis - Bottom-Up Factors :
1- Capacity is the borrower’s ability to make timely payments on its debt obligations.
2- Capital refers to the resources at an issuer’s disposal to reduce its reliance on debt. Like capacity, this is a relatively quantifiable factor.
3- Collateral analysis is an assessment of the quality and value of the assets on an issuer’s balance sheet that can be used to support its indebtedness.
4- Covenants are contractual terms that lenders use to protect themselves against the possibility of managerial decisions that benefit shareholders at their expense.
5- Character analysis scrutinizes the quality of an issuer’s management team and seeks evidence of red flags, such as a previous use of aggressive accounting policies, fraudulent activities, or poor treatment of bondholders. Like collateral and covenants, this is a more qualitative factor.
Cs of Credit Analysis - Top-Down Factors :
1- Conditions include overall macroeconomic factors (e.g., GDP growth, inflation) that impact the ability of all borrowers to service their debt obligations.
2- Country considerations include both the geopolitical environment and the domestic legal system’s record of upholding bondholder’s rights.
3- Currency is a consideration whenever returns can be affected by fluctuating exchange rates, such as when issuers borrow in international markets.
A borrower is described as being illiquid to the extend that it is limited in its ability to access these sources of repayment.
Credit risk can be quantified in a single metric known as expected loss (EL), which is the probability-weighted amount that a lender can expect to lose on a debt investment. The value of an investor’s claim is called the expected exposure (EE) or the exposure at default (EAD), which is typically calculated as the bond’s face value net of the value of any collateral that has been pledged.
The two factors that determine expected loss are:
1- Default risk: The likelihood that a borrower defaults on its obligations. This component of credit risk is quantified by the probability of default (POD).
2- Loss severity: The percentage of an investment that an investor expects to lose if a borrower defaults, which is calculated as one minus the recovery rate (RR). When expressed in currency terms, this is measured as the loss given default (LGD), which is calculated as the product of loss severity and expected exposure.
The credit rating industry operates largely according to an “issuer pay” model issuers hire agencies to evaluate and rate their debts. Rating agencies meet with senior managers and have access to internal financial information and projections that are unavailable to the investing public.
No significant progress has been made toward the establishment of a new model without the inherent conflict of interest caused by the agency relationship.
Credit migration risk is the possibility that a borrower’s credit rating will be lowered.
Investment Grade (IG) : Moodys Baa3 and more, while Junk : Ba1 and lower
S&P and Fitch BBB- and more, while Junk : BB+ and lower
Credit Rating Considerations :
-Credit ratings are “sticky” because they change relatively infrequently, whereas market-determined credit spreads fluctuate daily. Rating also lag the market because agencies tend to maintain existing ratings even after market conditions indicate that a change is justified.
- Speculative-grade bonds that carry the same rating often trade at different yields because agencies base their ratings on assessments of expected loss, whereas market pricing of distressed debt is more influenced by estimates of default timing and recovery rates.
During periods of market turmoil, investors seek low-risk bonds in a “flight to quality” and buying government bonds. Spreads increase for all corporate bonds due to higher credit risk and reduced liquidity, but the impact is great for high-yield bonds.
The curve can become inverted for high-yield issuers during the contraction and early expansion stages.
A one-category rating downgrade causes a greater increase in the spreads of high-yield bonds compared to investment grade bonds.
Despite their greater risk, high-yield bonds offer several benefits for investors:
1- Portfolio diversification
2- Capital appreciation
3- Equity-like returns with lower volatility
The bid-ask spread quoted by dealers, influenced by two issuer-specific factors:
1- Issuer size: Bid-ask spreads are lower for the debt of issuers with more debt outstanding.
2- Credit quality: A wider spread will be quoted on the debts of less creditworthy borrowers, which trade less frequently than bonds issued by issuers with higher credit quality.
Issuer-Specific Factors :
Factors that affect an issuer’s ability to meet its debt obligations include the sufficiency of their cash flows, measures by debt coverage ratios, and their relative reliance on debt, measured by leverage ratios. Analysis of issuer-specific factors can help investors compare yields on the bonds of companies that operate in the same sector and have similar business models.
Yield : composed of a benchmark yield and a yield spread that includes compensation for credit risk and illiquidity.
Which of the following is most likely a significant risk of relying on credit ratings provided by agencies?
It can be difficult, if not impossible, to capture all of the risks faced by an issuer in a credit rating.
In contrast to high-yield credit analysis, investment-grade analysis is more likely to rely on:
A
spread risk.
B
an assessment of bank credit facilities.
C
matching of liquidity sources to upcoming debt maturities.
A) Most investors in investment-grade debt focus on spread risk—that is, the effect of changes in spreads on prices and returns—while in high-yield analysis, the focus on default risk is relatively greater.
Sovereign Credit Analysis - Qualitative Factors :
1- Government Institutions & Policy : Sovereign immunity is a legal principle that limits the ability of lenders from enforcing their claims in the same way that they would with a corporate issuer. When a sovereign issuer is unwilling to pay, the International Monetary Fund may work with investors to restructure the country’s debts.
2- Fiscal Flexibility
3- Monetary Effectiveness: Central bank independence is important to protect against political pressure to monetize government debt, which puts upward pressure on inflation and reduces the value of the domestic currency.
4- Economic Flexibility: Indicators of economic flexibility include income per capita, growth potential, and robust trading relationships. Economic diversification is important to prevent over-reliance on a single industry for tax revenues and sensitivity to commodity price fluctuations.
5- External Status: The ability of a sovereign borrower’s ability to meet its debt obligations is influenced by its policies on international trade, capital flows, and foreign exchange.
A credible monetary policy and exchange rate regime improve a country’s ability to attract foreign investment.
Emerging country governments that impose restrictions on exchange rates and capital flows may be limited in their ability to access international debt markets, making them more reliant on supranational organizations such as the IMF.
Sovereign Credit Analysis - Quantitative Factors :
1- Fiscal Strength:
- Debt burden: Debt-to-GDP; Debt-to-Revenue
- Debt affordability: Interest-to-GDP; Interest-to-Revenue
2- Economic Growth and Stability: Remain robust over the course of the business cycle.
- Size and scale: GDP in purchasing power parity terms; GDP per capita
- Growth and volatility: Real GDP growth rate; Standard deviation of real GDP growth
3- External Stability: A country is considered to be externally stable if foreign investors are willing to hold assets denominated in its domestic currency.
- Currency reserves: FX reserves/GDP; FX reserves/External debt (Reserve ratio)
- External debt: Long-term external debt/GDP (External debt burden); External debt due within 1 year/GDP (External debt due)
Non-sovereign issuers include supranational organizations that have been created by national governments, national-level agencies and institutions, and sub-national (regional) governments. The key factor in rating these issues is whether they enjoy the implicit or explicit backing of a sovereign issuer.
Agencies are created by governments with a mandate to provide specific public services. Being a legally-distinct entity allows an agency to issue debt to finance its operations.
Supranational organizations are entities such as the World Bank that have been jointly created by national governments to pursue common international objectives.
Member states with emerging economies can access credit facilities through supranational organizations that allow them to borrow at lower rates than they would pay on their own debt issues.
In the United States, all governments below the national level are known as municipal issuers.
- General obligation bonds: are unsecured issues backed by general tax revenues. As with sovereign debt, credit risk analysis focuses primarily on the strength of the jurisdiction’s economy and the government’s commitment to prudent fiscal management.
More exposed to the risks of demographic and technological change and no use of monetary policy and have more limited fiscal powers.
- Revenue bonds: are issued to finance a specific project, such as a toll road.
Riskier than general obligation bonds.
Many revenue bonds include a minimum debt service coverage ratio covenant (similar to corporate issuers credit analysis).
Which of the following statements about the US municipal bond market is least likely correct?
A
Municipal bonds are issued by both cities and states
B
Municipal bond yields do not include a credit risk premium
C
Municipal borrowers may issue bonds on behalf of private entitie
B) In the United States, bonds issued by state and city governments and their agencies are called municipal bonds. These issuers often borrow on behalf of private entities (e.g., hospitals).
However, it is incorrect to claim that municipal bond yields do not include a credit risk premium. Although municipal bond defaults are historically less common than for similarly-rated corporate bonds, they do occur and investors will require additional yield as compensation for this risk.
Assessing Corporate Creditworthiness - Qualitative Factors :
1- Business Model : Does a company’s business model allow it to deliver its value proposition to its target customers?
2- Business Risk : Issuer-Specific: Are revenues and profit margins stable and predictable?
3- Industry and Competitive Environment :
What is the level of industry concentration and how does this impact the rivalry among competitors?
4- Corporate Governance : Can the company be trusted to use the debt proceeds as specified?
Assessing Corporate Creditworthiness - Quantitative Factors :
1- Profitability: As the primary source of repayment, profits and cash flows should be robust.
2- Leverage: Lenders prefer a lower debt burden, as quantified by metrics such as debt-to-assets or debt-to-EBITDA.
3- Coverage: The creditworthiness of borrowers depends on their ability to generate sufficient cash flows to service their fixed obligations, which include debts (both interest and maturity principal) and debt-like commitments such as long-term leases.
4- Liquidity: Ability to meet its short-term obligations.
There are several measures of cash flow that can be used in ratio analysis:
Free cash flow (FCF) before dividends is net income plus depreciation and amortization minus working capital increases, capital expenditures, and net interest paid. Companies with negative free cash flow must seek additional financing.
Funds from operations (FFO) is net income from continuing operations, plus depreciation, amortization, deferred income taxes, and other non-cash items.
Retained cash flow (RCF), also known as net cash flow from operating activities less dividends paid is a relatively conservative metric because it subtracts the contribution of cash flows that have been distributed to shareholders.
Coverage ratios measure an issuer’s ability to “cover” its interest payments. As with leverage ratios, inputs may be adjusted. Specifically, interest expense may be increased by the amount of any lease payments and/or decreased by the interest income generated from cash and marketable securities.
Seniority has a significant impact on estimates of the recovery rate and loss given default. Secured debts, which give lenders a direct claim on certain assets and cash flows, have higher seniority rankings than unsecured obligations.
The debts that rank highest in terms of seniority are first mortgage debt, which is backed by specified property (e.g., plants, office buildings), and first lien debt, which may include pledges of real property or other assets (e.g., equipment, patents).
Junior secured debt are third lien loans that are backed by assets and rank above unsecured obligations.
Unsecured debt only has a general claim on the issuer’s assets.
Subordinated debt obligations rank lowest in terms of seniority, with junior subordinated lenders having near-zero recovery rates.
The principle of pari passu ensures that all creditors within the same seniority ranking have the same claim in bankruptcy, regardless of the maturity of the debt they hold.
In general, lower recovery rates in industries that are undergoing secular decline compared to those in industries that are experiencing a cyclical downturn.
The composition of a company’s capital structure is also important. Recovery rates will be lower for unsecured lenders if a company has issued more secured debt.
In general, liquidation results in higher recovery rates for bank lenders and senior creditors. In the event of a subsidiary’s liquidation, all creditor claims must be settled before any remaining funds can be “upstreamed” to the parent.
An issuer rating refers to the borrower’s overall creditworthiness and is generally considered to be the rating that would be applied to its senior unsecured debt. Issue ratings account for a specific obligation’s seniority ranking, so they may be higher or lower than the issuer rating.
Cross-default provisions ensure that a default on any debt triggers a default on all of an issuer’s debts. Because of this, a company’s bondholders face the same POD, regardless of seniority.
Notching is the methodology that is used to adjust an issue rating relative to the issuer rating based on differences in seniority and sources of repayment. In general, notching adjustments are smaller for companies with higher issuer ratings. Taking measures to reduce an issue’s expected loss severity is more likely to be a concern for less creditworthy issuers.
A company issued a new series of bonds. In the event of default, the bondholders have the highest claim among general creditors to all of the company’s assets that have not been specifically pledged as collateral. The newly-issued debt is most accurately categorized as:
A
unsecured debt.
B
second lien debt.
C
senior subordinated debt
A) In the event of default, unsecured debtholders have a general claim to assets that have not been specifically pledged as collateral to back higher priority claims.
Second lien debt is backed by a specific asset (such as real property or personal property) as collateral.
The claims of senior subordinated debtholders are not backed by specific assets, but rank below the claims of unsecured debtholders.
Securitization is the process of creating streams of cash flows from an underlying pool of assets. Ownership of these assets is transferred to a special legal entity that issues asset-backed securities (ABS).
Covered bonds are issued by financial institutions and backed by a segregated pool of specifically identifiable assets, such as mortgage loans.
Dual recourse = investors have claims against both the issuer and the assets in the segregated pool. This grants an additional layer of protection against default risk.
Covered bonds are different from securitizations in two important ways:
1- The assets in the segregated pool remain on the issuer’s balance sheet.
2- Cash flows go directly from the issuer to investors without passing through an intermediary.
Like covered bonds, pass-through securities are backed by an underlying pool of assets. But these are true securitizations because the assets are transferred from their owner to a legally distinct entity that the cash flow from these assets “pass through” before they are received by investors.
The best-known examples of the pass-through structure are mortgage-backed securities (MBS), which have mortgage loans as their underlying assets. These may be residential mortgage-backed securities (RMBS) based on home mortgage loans or commercial MBS (CMBS) backed by loans on various types of commercial properties.
Examples of non-mortgage backed securities include:
Collateralized Debt Obligations (CDOs)
Collateralized Loan Obligations (CLOs)
Collateralized Bond Obligation (CBO)
Collateralized Debt Obligation Squared (CDO Squared)
Benefits to Issuers : Securitization has allowed banks to remove illiquid loans from their balance sheets. This reduces their capital requirements and allows banks to operate more efficiently on a risk-adjusted basis. An additional benefit of securitization for banks is that they are able to extend more loans, which generates more origination fees.
Benefits to Investors : Securitization allows investors to access cash flows from private loans without incurring the costs associated with originating and servicing these obligations.
Securitization allows investors to make choices that match their specific objectives, constraints, and liabilities.
Benefits to Economies and Financial Markets : More funds available to borrowers at a lower cost and improves the liquidity and efficiency of the overall financial system.
The risks of securitization include the possibility that the underlying cash flows may be received sooner or later than expected (contraction risk and extension risk, respectively).
Also credit risk (defaults on the underlying loans)
An automobile manufacturer that wants to raise €1,000 million. Rather than issuing new bonds, the company chooses to securitize €1,000 million in auto loans that it has extended to help its customers finance their purchases. The steps in this securitization process are:
1- he manufacturer sells automobiles to its customers on credit
2- The manufacturer establishes a legally distinct special purpose entity (SPE)
3- The SPE purchases loans from the manufacturer, which now has €1,000 million in cash
4- The SPE creates securities backed by the loans acquired from the manufacturer
5- Investors purchase securities from the SPE
6- Loan payments from customers are received by the SPE
7- The SPE distributes cash flows to investors
There are three key parties to a securitization:
1- The seller (or depositor) originates the assets that are used as collateral
2- The issuer is the legally distinct SPE, also known as a special purpose vehicle (SPV), that is established to create the asset-backed securities
3- The servicer collects payments on the underlying loans
Other third parties that are involved in a securitization include:
- Lawyers to draft the sale agreements as well as the prospectus for the security issue
- Investment banks to underwrite the securities
- A financial guarantor to insure the performance of the underlying assets
- Rating agencies to assess the credit risk of the securities
- Trustees, typically financial institutions, to safeguard the assets that have been transferred to the SPE and hold funds that are due to be transferred to investors
As a legally distinct entity, an SPE is bankruptcy remote from the depositor. Once assets have been transferred to an SPE, they are no longer owned by the depositor and cannot be claimed by its creditors in the event of a bankruptcy.
Ex: if a bank securitizes a pool of loans, investors who purchase the securities are only exposed to the risk that the borrowers will be unable to repay their loans, not the risk that the originating bank will fail.
The important differences between a covered bond and an ABS are listed below :
Covered bond investors who have dual recourse, meaning that they have claims against both the issuer and the assets in the segregated pool.
The loans pledged to back a covered bond remain on the originating bank’s balance sheet rather than being transferred to a special legal entity.
Covered bond issues are typically with only one bond class per credit pool, while the underlying assets for an ABS support multiple tranches with different risk exposures.
The issuer of a covered bond must replace any loan in the pool that is deemed to be non-performing.
The total value of the pool of assets pledged as collateral is often greater than the face value of the covered bond. This overcollateralization gives investors even greater protection against credit risk.
- A hard-bullet covered bond triggers a default as soon as the issuer fails to make a payment and investors receive their cash flows from the underlying mortgages on an accelerated schedule.
- A soft-bullet covered bond delays the default declaration and acceleration of payments to investors until a new final maturity date, which is typically up to one year after the original maturity date.
- A conditional pass-through covered bond converts to a pass-through security on the original maturity date and continues making payments until all commitments to investors have been met.
ABS Structures to Address Credit Risk :
In order to mitigate credit risk, ABS are structured with various forms of credit enhancement, which may be internal or external in nature. External credit enhancements include cash collateral accounts, letters of credit, and financial guarantees from banks or insurers.
Internal credit enhancements structure the underlying assets to absorb potential losses. Common mechanisms include overcollateralization, excess spread, and credit tranching (subordination).
Excess spread is created by issuing ABS obligations with a coupon rate that is lower than the rate on the underlying loans. For example, a 4% coupon ABS based on 6% mortgages will build up cash reserves from the excess spread.
Credit tranching involves the use of a waterfall structure with subordinated tranches that reduce credit risk for more senior tranches by absorbing the first losses from defaults on the underlying loans. Creating multiple tranches to absorb losses sequentially allows investors to choose their preferred level of exposure to credit risk.
200M
Class A : 170
Class B : 20
Class C : 10
Losses for A start when losses exceed 30m, and Classes B & C are completly wiped.
Non-Mortgage Asset-Backed Securities :
Many non-mortgage assets can be pooled as collateral to back a securitization, including auto loans, business loans, accounts receivable, and credit card debt. A key consideration with ABS is whether the underlying collateral is amortizing or non-amortizing.
Non-amortizing loans, such as credit card debt, do not have scheduled principal repayments. Asset-backed securities based on these types of obligations are typically structured with a revolving (lockout) period during which any principal repaid is reinvested to acquire an equivalent amount of additional loans. The amortization period starts at the end of the lockout period and continues until the stated maturity date of the ABS. Any principal repayments received during this second phase are distributed to ABS holders according to their tranche rather than used to acquire replacement loans for the pool.
For MBS: the composition of the pool of underlying assets is static and its value shrinks over time. Mortgages are not replaced when they reach maturity, or if they default or are repaid early. Prepayments are allocated among tranches based on established rules.
Credit Card Receivable ABS :
Credit card issuers use securitization to remove receivables from their balance sheets. From their perspective, the benefits of securitization include capital efficiency, lower funding costs, reduced default risk exposure, and additional fee income.
The cash flows generated by a pool of securitized credit card receivables include principal repayments, interest charges, and fees for late payments or annual memberships. Interest rates may be fixed or floating, but are typically subject to a cap.
Rapid (early) amortization provisions are used to ensure that they protect the credit quality of the ABS if specific events occur. For example, if default rates are higher than expected and there is ABS is at risk of becoming undercollateralized, a rapid amortization provision is triggered and investors have their principal returned on an accelerated schedule.
Solar ABS:
Solar loans may be backed by a lien on the equipment or they may be structured as home improvement loans, which effectively makes them subordinated mortgages. Combining multiple liens together reduces the default risk of a solar ABS.
It is common for solar ABS to include a pre-funding period after the close of the transaction during which additional assets may be added to the pool. This provision benefits investors by diversifying the pool.
Collateralized debt obligation (CDO) is a broad term for securities that are backed by a diversified pool of debt obligations. Examples of CDOs include:
1- Collateralized bond obligations (CBOs): Backed by corporate and emerging market bonds
2- Collateralized loan obligations (CLOs): Backed by bank loans
3- Structured finance CDOs: Backed by ABS, RMBS, CMBS, and other CDOs
4- Synthetic CDOs: Backed by credit default swaps and other structured securities
The equity tranches do not pay a coupon rate. Rather, these investors receive the residual return in excess of payments to more senior tranches and the CDO manager’s fees. Of course, they risk the possibility of less-than-expected returns or even the loss of their entire investment. Equity tranches are key to the viability of a CDO because there must be enough investors who are willing to take on the associated risk in exchange for high expected returns.
CLO : The manager may begin to assemble the collateral pool as soon as funds become available, but its composition is typically not finalized until all capital has been raised. Once the transaction closes, there is a ramp-up period during which loans are added to complete the portfolio. After this phase, the manager is permitted to replace loans with any new assets that meet the criteria for inclusion in the portfolio. As the underlying loans mature, cash flows are allocated to tranches according to the specified order of payments.
To monitor the manager’s ability to make payments, CLO investors impose collateral limits and require managers to meet performance tests and collateral limits. For example, an overcollateralization test requires the value of the loan pool to remain above a specified threshold, such as 110% of the face value of CLO tranches. If this overcollateralization ratio is breached, cash flows are diverted to the most senior tranches until the test can be met again. The effect is to deleverage the CLO by reducing the capital provided by its lowest cost source of funds. Each tranche of a CLO has its own target overcollateralization ratio.
Unlike securitized products, covered bonds have the following features:
- Collateral remains on the issuer’s balance sheet rather than being transferred to a separate entity.
- There is only one bond class per pool of assets rather than multiple tranches with different risk/return profiles.
- Investors have dual recourse to both the pledged assets and the issuer, while ABS investors only have recourse to the collateral pool.
Mortgage Loans and their Characteristic Features :
The loan-to-value ratio (LTV) is the ratio of the mortgage amount to the property’s purchase price. A lower LTV ratio means that the borrower is less likely to default, and the lender is more likely to be made whole from foreclosure.
The debt-to-income ratio (DTI) is used to measure a borrower’s credit quality. DTI is calculated as a monthly mortgage payment as a percentage of a borrower’s gross pre-tax income.
Rights of the Lender in a Foreclosure :
A mortgage is described as being “underwater” if the value of the property is less than the amount of outstanding principal (i.e., the LTV ratio is greater than 1).
If a mortgage is a recourse loan, which is standard in Europe, the lender can require the borrower to make up the difference between the outstanding loan and the sale price.
With non-recourse loans, which are more common in the United States, lenders have no claim beyond the proceeds of a foreclosure sale. However, this choice will have a negative effect on a borrower’s creditworthiness and ability to access funds in the future.
Prime loans have been granted to borrowers with high credit quality. They have good credit history and sufficient income to service their mortgage obligations. Subprime loans either have borrowers with low credit quality, or the loan is not the first lien on the property.
Agency and Non-Agency RMBS:
One type of agency RMBS is based on a pool of loans that carry performance guarantees from a government agency and are backed by the government’s full faith and credit. Another type of agency RMBS are issued by a government-sponsored enterprise (GSE) and has a collateral pool of mortgages that meet specified minimum criteria.
The GSE guarantee the payments to security holders (although this guarantee does not carry the full faith and credit of the government sponsor).
Mortgages that do not meet the criteria for inclusion in agency RMBS (non-conforming mortgages) may be pooled into privately issued pass-through securities called non-agency RMBS that do not carry any form of government guarantee.
Prepayment Options and Prepayment Penalties :
Borrowers often have the right to pay more than the scheduled amount of principal. A prepayment option allows a borrower to repay some or all of the outstanding principal.
To mitigate this prepayment risk and achieve more certainty over the timing of incoming cash flows, lenders impose penalties on early retirement of mortgage principal.
Time Tranching :
Prepayment risk is more broadly defined as the possibility for principal repayments to be made at an unanticipated pace.
When prepayments come in earlier than scheduled due to a decrease in interest rates, this is known as contraction risk. Not only do prepayments leave investors with cash to reinvest in a low interest rate environment, they also reduce the duration of an MBS and limit its potential price appreciation.
It includes extension risk, if interest rates increase, homeowners will not be motivated to prepay mortgages. Investors will have less cash than anticipated to be reinvested in this higher interest rate environment. Expected cash flows have a lower present value because they will take longer to receive and they are being discounted at a higher rate.
Time tranching is the allocation of incoming cash flows to different tranches according to timing rules. For example, tranches can be prioritized in terms of the order in which they receive principal repayments. This ensures that certain classes of bonds will absorb prepayments before other classes are affected.
Residential mortgage-backed securities (RMBS) are based on pools of home mortgage loans. Investors receive cash flows in the form of interest, scheduled principal payments, and prepayments. RMBS are commonly structured as either mortgage pass-through securities or collateralized mortgage obligations.
Mortgage pass-through securities are shares that represent a claim to the cash flows from an underlying pool of mortgages, but without rules to allocate cash flows differently among tranches. In other words, cash flows simply pass through to all investors in the same way. The amount of cash flow received by investors is reduced by the servicing and administrative fees that issuers and third parties charge for activities such as collecting payments, sending payment notices, maintaining records, and providing tax information. The pass-through rate earned by investors is the net interest rate on the underlying mortgages after accounting for the deduction of administrative fees.
Because the underlying mortgages that have been collateralized are not identical, a weighted average maturity (WAM) and weighted average coupon rate (WAC) are calculated based on the outstanding value and coupon rate of each mortgage in the pool. The WAM is used by investors to indicate the amount of time before an MBS will be repaid, assuming constant interest rates and prepayment rates.
Redistribute cash flows among multiple tranches does not eliminate or even reduce overall prepayment risk and credit risk, but it does allow investors to choose their desired levels of exposure.
In a basic sequential-pay CMO structure, each tranche receives the same coupon rate, but all scheduled principal payments and prepayments are directed to one tranche until its full par value is repaid. After that, principal payments are directed to the next tranche. This is done until all tranches are completely paid off.
Investors who hold tranches that are filled later are protected against contraction risk by the higher priority tranches that absorb the first prepayments. Conversely, the first tranches to be filled are protected against extension risk because they will receive principal payments from all of the underlying mortgages until they are repaid.
Sequential-pay tranching structure does not eliminate all uncertainty about the timing of cash flows. The average life of each tranche will vary depending on the actual prepayment rate.
Other CMO Structures :
1- Z-Tranches (also known as accretion bonds or accrual bonds)
2- Principal-only (PO) tranches receive only the principal repayments (including prepayments) from the underlying pool of mortgages. Their value is very sensitive to interest rates, increasing when prepayments increase due to falling rates.
3- Interest-only (IO) tranches complement PO tranches by receiving only interest payments from the pool. Unlike PO tranches, these have no par value. Cash flows to IO tranches are decreased in low interest rate environments due to the increase in principal prepayments.
4- Floating-rate tranches can be created in CMO, even one that is based on a pool of exclusively fixed-rate mortgages. This is accomplished by creating an inverse floating-rate tranche to offset the floating rate tranche.
5- Residual tranches receive only the cash flows that remain after obligations to all other tranches have been met. They are attractive to investors with higher levels of risk tolerance.
6- Planned amortization class (PAC) tranches give investors even more protection against prepayment risk than sequential-pay CMOs. This is accomplished by having a support tranche to absorb all principal payments in excess of what is required to satisfy the schedule of the PAC tranches. If the actual prepayment rate stays within an expected range, each PAC tranche will be repaid on schedule.
Commercial Mortgage-Backed Securities (CMBS) :
Like residential CMOs, CMBS are structured in tranches. A residual tranche, also known as an equity tranche, absorbs the first default losses from the underlying pool of mortgages.
Call Protection :
As noted earlier, contraction risk is a significant concern for RMBS investors. Repaying mortgage principal ahead of schedule is equivalent to exercising a call option.
1- Structural call protection at the CMBS level is achieved with sequential payments based on each tranche’s credit rating. The highest-rated tranches are repaid before those with lower ratings and default losses are absorbed by the lowest-rated tranches.
2- Loan-level call protection comes from the following mechanisms:
- Lockout periods during which prepayments are prohibited
- Prepayment penalty points that borrowers must pay the SPE to refinance, such as 1% of the outstanding loan balance
- Defeasance provisions that require the borrower to purchase a portfolio of government securities that replicate the future cash flows that the lender would receive in the absence of prepayments
balloon risk is a form of extension risk.
Commercial mortgages are typically not fully amortizing, meaning that they require large principal payments at maturity. Failure to make this “balloon payment” triggers a default. Lenders can mitigate this risk by extending the loan over a workout period during which the borrower pays a higher mortgage rate. However, this extends the time until CMBS investors receive their cash flows.
Because the loan has a non-recourse feature, the lender can look to only the underlying property to recover the outstanding mortgage balance and has no further claim against the borrower. The lender is simply entitled to foreclose on the home and sell it.
Structural subordination can arise when a corporation with a holding company structure has debt at both its parent holding company and operating subsidiaries. Debt at the operating subsidiaries is serviced by the cash flow and assets of the subsidiaries before funds are passed to the parent holding company.
