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Fabozzi: Investment Management Graphics by
• You will discover the different types of fixed-income securities. • You will understand the fundamental features of bonds. • You will learn about the different types of securities issued by the Treasury. • You will be able to show how zero-coupon Treasury securities are created. • You will study the provisions for paying off a corporate bond issue prior to the maturity date. • You will investigate the different credit ratings for a corporate bond issue.
• You will understand the two types of municipal bonds: general obligation bonds and revenue bonds. • You will be able to identify types of securities issued in the Eurobond market. • You will discover the characteristics of preferred stock. • You will study the cash flow characteristics of a mortgage loan and the meaning of prepayment risk. • You will explore the three types of mortgage-backed securities: mortgage pass-through securities, collateralized mortgage obligations, and stripped mortgage-backed securities. • You will investigate the different types of asset-backed securities.
In this chapter we turn to another major asset class, fixed-income securities. We will describe basic features and then discuss the variety of investment vehicles available in this asset group. This serves as an introduction to the rest of Section V.
Some definitions Fixed income security – issuer (borrower) agrees to make income payments fixed by contract Bonds (debt obligations) – borrower makes interest payments Preferred stock – an equity issue with fixed income payments of dividends Term to maturity – date when debt ceases, with maturity being that exact date and term denoting the number of years till that date Par value (maturity value, face value) – amount issuer agrees to pay at maturity Coupon – periodic interest payment made to bondholders Coupon rate – rate of interest usually paid semiannually for U.S. issues; multiplied by par value yields dollar value of coupon
Bond fundamentals Zero-coupon bonds – no periodic interest payments. principal and interest paid at term Floating rate security – coupon rate is reset periodically Insert Table 22-1 .
issued at a discount Notes – matures between 2-10 years.U with real rate being fixed .S. issued as a coupon security Bonds –maturities longer than 10 years Treasury inflation protection securities (TIPS) – principal is indexed to CPI. Treasury securities Bills – matures in one year or less.U.
75% $100. not price Yield on bank discount = Yd = D x 360 F t Yd = annualized yield on a bank discount basis (expressed as a decimal) D= dollar discount.000.431 Yd = $2. which is equal to the difference between the face value and the price F= face value t= number of days remaining to maturity Example: T = 100. F = $100.Quotation convention for Treasury bills Quotes are in terms of yield.000 100 . Price = $97.431 x 360 = 8.569 D = $100.569 = $ 2.000 – 97.
000 par value a change in price of 1% = $1000 with 1/32 = $31. with a basis of $100. Example: Quote of 92-14 = 92 and 14/32.Price quotation convention for Treasury coupon securities Notes and bonds trade on a dollar price basis in unites of 1/32 of 1% of par ($100). .25.
In essence. the security is stripped. Then a receipt is issued to investors representing an ownership in the account. They purchase these securities.Treasury securities refer to the firm they are associated with.Stripped Treasury securities Several major brokerages have created an investment vehicle from Treasury securities. Trademark zero-coupon . deposit them in a bank custody account and then separate out each coupon payment and principal. Treasury receipts (TRs) – generic receipts issued by a group of primary dealers in the government market representing ownership of a Treasury security .
Stripped Treasury securities STRIPS – U.S.S. ending trademark and generic receipts •Treasury strips .created from the principal payment at maturity . government.zero-coupons or stripped Treasury securities •Treasury coupon strips – created from the future coupon •Treasury principal strips . Treasury program issues these direct obligations of the U.
Federal agency securities There are two categories of federal agency securities: Government-sponsored enterprises securities market Federally related institutions securities markets .
S. government. only the Tennessee Valley Authority (TVA) has done so recently.Federally related institutions securities While a number of arms of the federal government are allowed to issue securities directly in the marketplace. These issues are backed by the full faith and credit of the U. .
Government-sponsored enterprise securities • • • • • • • • Federal Farm Credit Bank System Farm Credit Financial Assistance Corporation Federal Home Loan Bank Federal Home Loan Mortgage Corporation Federal National Mortgage Association Student Loan Marketing Association Financing Corporation (FDIC) Resolution Trust Corporation Except for farm related securities. government.S. these are not backed by the U. .
Bondholders have first claim to the income and assets of a corporation. Embedded option – options are embedded in the bond issue Bare option – trades separately from the underlying security Term bonds (bullet) – can be retired by payment at final maturity or paid off earlier if so stated in the bond indenture or contract Serial bonds – specified principal amounts are due on specified dates Medium-term notes – continuously offered to investors over a period of time . it is in default.Corporate bonds The issuer agrees to make coupon payments and repay the principal value of the bond at maturity. If the institution cannot pay.
real or personal property may be pledged. Insert Table 22-2 .Security for bonds Beyond the general credit standing.
Provisions for paying off bonds Call provision – issuer can buy back all or part of the issue prior to maturity Various types Call and refund provisions Sinking-fund provision Convertible and exchangeable bonds Issues of debt with warrants Putable bonds Floating-rate securities Special features in high-yield bonds .
Call and refund provisions Call provision Issuers want to be able to take advantage of falling interest rates in the future (i. often reaching par after a certain number of years have passed since issuance. Refunding Issuer cannot redeem bonds during first 5-10 years following issue unless the funds come from other than lower-interest cost money (cash flow. Corporate bonds are usually callable at a premium above par with the amount declining as the bond approaches maturity. . common stock sale proceeds). lower their debt costs) and call provisions are an embedded option for the issuer.e.
Sinking-fund provision •Indenture requires issuer to retire a specified portion of an issue each year in order to reduce credit risk •if only part is paid. remainder is a balloon maturity Sinking fund can be satisfied by -Making a cash payment of the face amount of the bond to be retired to the corporate trustee who then calls bonds using a lottery system -Delivering bonds to the trustee with a total face value = amount that must be retired from bonds purchased in the open market Embedded option – issuer can accelerate repayment of principal .
Convertible and exchangeable bonds Convertible bonds – Bondholder has the right to convert the bond to a predetermined amount of common stock of the issuer Exchangeable bonds – bondholder has the right to exchange the bonds for common stock of a firm other than issuer .
Issues of debt with warrants Warrants may allow holder the -Right to purchase a designated security at a specified price -Right to purchase the common stock of the debt issuer or another firm -Right to purchase a debt obligation of the issuer Warrants can be sold separately from the bond .
which lowers the bond value.Long put option on the bond Floating-rate securities Coupon interest is reset periodically based on some contrived interest rate (i. spread over Treasury bill .Putable bonds and floating rate securities Putable bonds Bondholder can sell the issue back to the issuer at par value on designated dates If interest rates rise after bond is issued.Non-putable corporate bond and 2. the bondholder can put the bond to the issuer for par Investor receives 1.e.
Deferred interest bonds sell at deep discount and do not pay interest for 3 –7 years Step-up bonds low coupon rate for initial period and then increases to a higher rate for the remainder of the term Payment-in-kind (PIK) bonds issuer can pay cash at a coupon date or give the bondholder a similar bond equal to the amount of the cash payment .Special features in high-yield bonds High-yield or junk bonds have a rating below triple B. where cash flow is severely restricted. deferred coupon structures are created. When used for an LBO or recapitalization.
.Credit ratings Insert Table 22-3 Ratings apply to the issue. not the issuer and are an opinion as to the issuers ability to meet its obligations.
Municipal securities These debt obligations are issued by state and local governments. Serial maturity – portion of the debt is retired each year Term maturity .debt is retired in maturities ranging from 20-40 years with sinking fund provisions beginning 5 –10 years prior to maturity Types of municipal securities General obligation bonds Revenue bonds Hybrid bonds . Their structures are either serial maturity or term maturity.
etc.General obligation bonds Many general obligation bonds are secured by the issuer’s unlimited taxing power.backed by taxes that are limited as to revenue source Full faith and credit obligations – used by larger issuers who have access to taxes beyond property taxes Double-barreled – revenue source includes fees. as well as taxing power . Limited-tax general obligation bonds . grants.
Revenue bonds These are bonds issued for project or enterprise financings where the revenues from the project are promised to the bondholders. sports complex bonds and water revenue bonds. universities. Examples include airports. All revenues from the enterprise are placed in a revenue fund with disbursements to funds covering -operation and maintenance fund -sinking fund -debt service reserve fund -renewal and replacement fund -reserve maintenance fund -surplus fund .
Hybrid bond securities Insured bonds – backed by insurance policies written commercially in addition to the credit of municipal issuer Refunded bonds (prerefunded bonds) – originally issued as G.O. government obligations .S. or revenue bonds but are now secured by an escrow fund consisting of U.
mostly traded in OTC market Euro straights – fixed-rate coupon bond with annual coupons Dual currency issues – interest and principal are paid in different currencies Convertible Eurobond – can be converted to another asset Many Eurobonds trade with attached warrants.offered.Eurobonds A Eurobond is 1. at issuance. . simultaneously to investors in a number of countries 3.underwritten by an international syndicate 2.issued outside the jurisdiction of any single country 4.
Preferred stock Preferred stock is not a debt instrument. but a senior security with dividends set at a percentage of par value (dividend rate). owner forgos the payment Perpetual preferred – issues without a maturity date . the dividend accrues until fully paid Non-cumulative preferred – if issuer cannot make a payment. -Promised returns to holders of preferred are fixed -Preferred holders have priority over common stockholders for dividends and liquidation distributions Cumulative preferred – if issuer cannot make a payment. However. 70% of this income is exempt from federal taxation if the recipient is a qualified corporation. -Dividends are a distribution of earnings.
and includes mortgage-backed securities such as -Mortgage pass-through securities -Collateralized mortgage obligations -Stripped mortgage-backed securities .Mortgages and mortgage-backed securities Mortgage market is the largest sector of the fixed-income market.
Mortgages A mortgage is a loan secured by the collateral of some specified real estate property which obliges the borrower to make a predetermined series of payments. . Interest rate = mortgage rate Conventional mortgage – loan is based on the credit of the borrower and the collateral for the mortgage (a residence). The lender can foreclose on the borrower is the debt is paid.
while the payment towards principal increases. Insert Table 22-4 .Cash flow characteristics of a mortgage loan Level-payment mortgage Borrower pays interest and principal in equal installments over a set period (maturity/term of mortgage) Each monthly payment consists of 1.A repayment of a portion of the principal The portion of the monthly payment applied to the interest declines each month.Interest of 1/12th of the fixed annual mortgage rate times the amount of the outstanding mortgage balance at the beginning of the previous month 2. This describes a self-amortizing loan.
Mortgage cash flow with servicing fee Servicing responsibilities include •Collecting monthly payments •Forwarding proceeds to owners of the loan •Sending payment notices to mortgagors •Maintaining records of principal balances •Maintaining escrow accounts for property taxes and insurance •Initiating foreclosure proceedings Cash flow from loan goes to 1.interest payment net of servicing fee 3.servicing fee 2.scheduled principal repayment .
pay off mortgages early by making prepayments (payments > scheduled payments) making cash flow uncertain. -Repossessed property -Destroyed property: insurance pay off the mortgage .Prepayments and cash flow uncertainty Loan holders can. and do. This occurs when -Homes are sold -If market rates fall. there is incentive to pay off the higher mortgage loan.
Mortgage pass-through securities A pass-through is created when mortgage holders form a collection or pool of mortgages and sell shares in the pool. This securitization causes payments to be made to shareholders each month. •pass-through coupon rate < pool’s mortgage rate = servicing fees •Due to cash flow uncertainty. Insert Figure 22-1 Insert Figure 22-2 . the prepayment speed is variable.
so is based on full faith and credit of U.timely payment of both interest and principal -Modified .Types of pass-throughs Agency pass-throughs -Government National Mortgage Association (Ginnie Mae) -Federally related institution. government -Federal Home Loan Mortgage Corporation (Freddie Mac) -Federal National Mortgage Association (Fannie Mae) Agency can guarantee two ways: -Fully modified . with principal payment simply guaranteed Non-agency pass throughs -Conventional pass throughs -Private-label pass-throughs .S.timely payment of interest only.
a security backed by a pool of pass-throughs •Several classes of bondholders (tranches) with varying maturities •Principal payments from the underlying are used to retire bonds •Set rules for prioritizing the distribution of principal payments among tranches •Prepayment risk is distributed among the tranches. lowering cash flow uncertainty Insert Figure 22-3 .Collateralized mortgage obligations (CMO) CMO .
Principal and interest are divided between two classes unequally. Insert Figure 22-4 . stripped mortgage-backed securities distribute the principal and interest unequally.Stripped mortgage-backed securities Instead of dividing the cash flow from the underlying pool on a pro rata basis.
.Asset-backed securities Securities backed by Credit card receivables Auto loans Home equity loans Manufactured housing loans These account for about 95% of the total market.
Cash flow stress and payment structure 4.Credit rating of the collateral 2.Quality of the seller/servicer 3.Legal structure .Credit risk In analyzing the risk of asset-backed securities we focus on: 1.
the reported experience Concentration risk – credit risk lessened by more borrowers in the pool (diversification). Credit enhancement – provides greater protection against losses due to borrower defaults. senior/subordinated debentures . Rating companies can set concentration limits on the amount of receivables from any one borrower. External – insurance. letters of credit. corporate guarantees.Credit quality of the underlying collateral Ratings companies look at the following -Borrower’s ability to pay -Borrower’s equity in the asset -The experience of originators of the loan vs. cash collateral reserves Internal – reserve funds.
Servicing history 2.Financial condition 7.Quality of the seller/servicer Loan originator or financial institution establishes underwriting standards. with the rating agencies evaluating the servicer of the loans.Experience 3.Originations 4.Servicing capabilities 5. Issues include 1.Human resources 6.Growth/competition/business environment .
.Cash flow stress and payment structure Cash flow = interest and principal repayment Payment structure Payment priorities Amortization of bond principal repayments How excess cash flow is used Depends on type of collateral Rating companies analyze structure to determine if the collateral’s cash flow meets the necessary payments.
Collateral sold to SPC SPC sells to the trust Trust holds collateral for investors SPC hold the interest retained by seller of collateral . the SPC will avert a bankruptcy court consolidation of the collateral with the assets of the seller. If the issuer enters bankruptcy.Legal structure Bankruptcy-remote special purpose corporation (SPC) SPC is the issuer of the asset-backed security. underlying loans are used for collateral for a debt instrument rater than general credit of issuer with the corporate entity retaining some interest. SPC is a wholly-owned subsidiary of the seller of the collateral.
borrower makes minimum periodic payment (credit card receivables. some home equity loans) payment < interest on loan balance shortfall + loan balance payment > interest on loan balance applied to reduction of balance Prepayments are projected based on changes in interest rates and refinancing prospects. . residential) Non-amortizing assets – no payment schedule.Cash flow of asset-back securities Collateral is either amortizing or non-amortizing Amortizing assets – borrower’s payments consists of scheduled principal and interest payments over life of loan (auto. home equity. estimated default rates and the recovery rate.
Types of asset backed securities •Auto loan •Credit card receivable-backed securities •Home equity loan-backed securities •Manufactured housing-backed securities .
Auto loan Issued by Financial subsidiaries of auto manufacturers Commercial banks Independent finance companies Cash flow Scheduled monthly loan payments (interest and principal). amortized Prepayments resulting from Sales and trade-ins requiring full pay off Repossession and resale Loss or destruction of vehicle Cash payoff to save on interest cost Refinancing of loan at lower interest cost .
Auto loan Pass through structure – senior tranche and subordinated trance with an interest-only class (used for smaller deals) Pay through structures – senior pieces tranched to create a range of lives with untranched subordinated piece (larger deals) Credit enhancement Senior/subordinated structure: cash reserves or overcollateralization .
Early amortization – occurs if trust is not able to generate enough income to cover coupon and fees. finance charges Interest to security holders paid periodically (fixed or floating) Lockout (revolving) period – principal payments made by credit card borrowers in the pool are retained by trustee and reinvested in more receivables. principal is paid to investors. retailers. default of services.Credit card receivable-backed securities Issued by Banks. principal. issuer violates pooling and servicing agreements .after lockout period (18 months – 10 years). travel and entertainment companies Cash flow Net interest. Principal-amortization period .
Credit card receivable-backed securities Amortization structures Pass-through – princiapl from accounts paid to secuity holders on a pro rata basis Controlled-amortization – scheduled principal amount established Bullet payment – amount distributed in a lump sum. with principal paid to a trustee monthly into an interest generating account for an accumulation period Credit enhancement Cash collateral account Collateral invested account .
Home equity loan-backed securities Home equity loan (HEL) – backed by residential property. prepayments Prepayments add uncertainty to the cash flow. usually a second lien Closed end – similar to fully amortizing residential mortgage loan Open end – homeowner has credit line up to the amount of equity in the property Cash flow Net interest. . scheduled principal payments.
these securities are backed by loans for manufactured homes (mobile homes). making refinancing imprudent.Manufactured housing-backed securities Issued by Ginnie Mae and private entities. Ginnie Mae loans are guaranteed by FHA or VA Other issuers. Also. such as Green Tree Financial. . prepayments Prepayments are more stable since the loan balances are small. the rate of depreciation is high in the earlier years making it harder to refinance the loan. scheduled principal payments. Loans last 15-20 years with fully amortized loan repayment. Cash flow Net interest. make conventional loans and make conventional manufactured housing backed securities.
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