DEBT MARKET INNOVATIONS

Compiled by:-

Akhil Kohli
Aditya Mehandiratta
Amandeep
Rishi Malhotra
Amit Gulati
 CONTENTS
• INTRODUCTION
• ZERO COUPON SECURITIES
• MORTGAGE backed and Asset Backed Securities
• Defeasance
• The REPO/REVERSE Market
• JUNK BONDS
• SHELF REGISTRATION
• FLOATING RATE PREFERRED STOCK & FLOATING
RATE DEBT
 INTRODUCTION
• FIXED INCOME SECURITIES were the foundation of the
innovations done by the Financial engineers.

• As the risk increases, there is an instrument for you

• The instruments discussed by us are singled out because of

their monumental significance, and they set the stage for
other instruments that followed and will follow
 TYPES OF RISK
• Various types of risk to which a holder of a fixed income
securities is exposed to are :-

1. INTEREST RATE RISK

2. DEFAULT RISK
3. REINVESTMENT RISK
4. CALL or PREPAYMENT RISK
5. PURCHASING POWER RISK
In the conventional Fixed income securities market, interest rate
risk can be managed by :-

1. MATURITY – HORIZON matching approach

2. Invest in instruments having maturity shorter than investors
horizon and then rollover into other instruments of short
maturity
3. Invest in instruments having maturity greater than horizon

CALL RISK or PREPAYMENT RISK is the risk that the investor is

repaid the loan principal prior to the expected date.

TREASURY INSTRUMENTS are ideal in removing the interest rate

risk and default risk but reinvestment risk still prevails.
 ZERO COUPON SECURITIES
• Debt instrument that is sold at a deep discount from face
value and no periodic coupons paid. At maturity, zeros are
redeemed for full face value.

• So, no reinvestment risk !!!

• Also tax benefits in form of TAX DEFERRAL

 PATH to ZERO COUPON BONDS
• The first zero coupon products was introduced by Merill Lynch
known as Treasury Investment Growth Reciepts (TIGRs)

• The creation of TIGRs is a 3 stage process

1. Coupons removed from traditional treasury based securities,
thereby separating coupons and final redemption into
separate cash flows
2. These individual cash flows then used to create irrevocable
trusts with a custodial bank.
3. Custodial bank issued shares in the trust known as TIGRs
• Given many advantages, the competition grew with various
other investment banks creating their own products.

• In 1984, Treasury created its own program of creating bonds,

called SEPERATE TRADING OF REGISTERED INTEREST AND
PRINCIPAL OF SECURITIES (STRIPS).

• Stripping is the process of separating a standard coupon-bearing

bond into its individual coupon and principal components. For
example, a 5 year coupon bearing bond can be stripped into 10
coupon and one principal instruments, all of which thenceforth
would become zero coupon bonds which remain direct obligation
to the government
 In India
• Finance Minister introduced Zero Coupon Bonds in Fianance
Bill, 2005
• Section 2(47) of Income Tax Act 1961 amended in 2005
includes maturity or redemption of zero coupon bond.
The profit received by an investor on maturity of Zero Coupon
Bond or redemption of the Zero Coupon Bond would be
treated as a capital gain
Similarly, if the Zero Coupon Bonds were held for not more
than 12 months immediately preceding the date of its transfer
then the gains so received by the taxpayer would be treated
as short-term capital gains.
 Short term capital gains are treated as income and hence come
under slabs of income tax while Long term capital gain, the tax
liabilities are covered under Section 112 of Income Tax Act
1961.

• Further, no TDS (Tax deduction at source) is charged on Zero

Coupon Bonds.

•So to sum up, ZEROS provide investors with assured growth in

three ways
1. They will know exactly how much money they will receive
when the bond matures.
2. They will know exactly when they will receive that money.
3. They do not have to worry about reinvesting the small
amounts of interest regular full-coupon bonds pay.
 Mortgage Loans
• A mortgage loan is a loan secured by the collateral of
some specified real estate property which obliges the
borrower to make a predetermined series of
payments.
• Conventional mortgage: a fixed rate, level-payment,
fully amortizing mortgage.
• Fully amortizing mortgage i.e. at the end of loan term
there is no mortgage principal balance outstanding.
• The cash flows for a mortgage loan are monthly and
consist of three components:
1. Net interest
2. Scheduled principal payment
3. Prepayment (if any)
 Mortgage Variants
• Adjustable Rate Mortgages
• Graduated Payment Mortgages
• Graduated Equity Mortgages
• Pledged Account Mortgages
• Shared Appreciation Mortgages
 Mortgage-Backed Securities
• A MBS is a security created when one or more
holders of mortgages form a pool of mortgages and
sells share or participation certificates in the pool.
• When a mortgage is used as collateral for MBS, the
mortgage is said to be securitized.
• Cash flows of MBS are backed by the principal and
interest payments of a set of mortgages.
• MBS owner holds a pro rata claim to all interest and
principal repayments.
 Additional Prepayment Risk
• The risk associated with the early unscheduled return
of principal on a fixed-income security. 
• The yield-to-maturity of such securities cannot be
known for certain at the time of purchase since the
cash flows are not known.
• Prepayments occur for a variety of reasons including
the sale of the home, a sudden availability of funds
for the homeowner, the death of the homeowner, or
a refinancing of the mortgage in response to lower
interest rates.
 Reasons for Issuing MBS
• Transform relatively illiquid, individual financial assets
into liquid and tradable capital market instruments.
• Allow mortgage originators to replenish their funds,
which can then be used for additional origination
activities.
• More efficient and lower cost sources of financing .
• Allow issuers to remove assets from their balance
sheet, which can help to improve various financial
ratios.
 Types Of MBS
Mortgage-backed security sub-types include:
• Pass-through mortgage-backed security-A pool of
fixed-income securities backed by a package of assets.
These can be subdivided into:
Residential mortgage-backed security (RMBS) - A
pass-through MBS backed by mortgages on
residential property.
Commercial mortgage-backed security (CMBS) - A
pass-through MBS backed by mortgages on
commercial property.
•Collateralized mortgage obligation (CMO) - A more
complex MBS in which the mortgages are ordered into
tranches by some quality (such as repayment time), with
each tranche sold as a separate security.

•Stripped mortgage-backed securities (SMBS): Each

mortgage payment is partly used to pay down the loan's
principal and partly used to pay the interest on it. These
two components can be separated to create SMBS's, of
which there are two subtypes:

Interest-only stripped mortgage-backed
securities (IO) - A bond with cash flows backed by
the interest component of property owner's
mortgage payments.


Principal-only stripped mortgage-backed
securities (PO) - A bond with cash flows backed by
the principal repayment component of property
owner's mortgage payments.
 Another Classification
• Single-Class MBS
In a single-class MBS, the pool arrangement allows
for the pass-through of all interest and principal
repayments to investors on a pro rata basis.
Thus, all the investors in the same pass-through
instrument hold identical securities with identical
cash flows, identical maturities and identical rights.
• Multi-Class MBS
Multi-class MBS are vehicle by which an issuer can
restructure interest and principal payments on
mortgage assets into separately tradable interests.
Examples, Collateralized mortgage obligation (CMO)
real estate mortgage investment conduits (REMICs)
and stripped mortgage-backed securities (SMBS).
 Collateralized Mortgage Obligations
• A type of mortgage-backed security that creates separate
pools of pass-through rates for different classes of
bondholders with varying maturities, called tranches.
• The repayments from the pool of pass-through securities
are used to retire the bonds in the order specified by the
bonds' prospectus.
• There are various variants of the basic CMO like CMOs in
which more than one tranche receives principal at a time,
zero coupon-like CMO tranches and there are CMOs
based on adjustable-rate mortgages.
 Zero-Coupon Like CMOs
• In these CMOs, one or more tranches take the form
of accrual.
• The accrual bond doesn’t receive any interest or
principal until such time as the preceding tranches
are fully retired and in the meanwhile, the interest
that would normally flow to tranche accrues.
 Asset Backed Securities
• Financial security backed by a loan, lease or receivables
against assets other than real estate and mortgage-backed
securities.
• An ABS is essentially the same thing as a mortgage-backed
security, except that the securities backing it are assets such as
Auto loans
Credit card receivables
Student loans
company's receivables
Royalties
 REFERENCES

• JOHN F. Marshal, Vipul K. Bansal FINANCIAL ENGINEERING

• http://www.open-ira.com/Bonds/Zero_Coupon_Treas_Bonds/Assured_Gr
owth.htm
• http://www.moneycontrol.com/news/fixed-income/zero-coupon-bonds-c
oming-soon-tostore-near-you_212868.html