Chapter 22

Fixed-Income Securities

Fabozzi: Investment Management

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Learning Objectives
• 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.
Learning Objectives
• 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.
Introduction
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.
Bond fundamentals
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

U.S. Treasury securities
Bills – matures in one year or less, issued at a discount

Notes – matures between 2-10 years, issued as a coupon

security

Bonds –maturities longer than 10 years

Treasury inflation protection securities (TIPS) –

principal is indexed to CPI- U with real rate being fixed
Quotation convention for Treasury bills
Quotes are in terms of yield, 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, 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 = $100,000, Price = $97,569
D = $100,000 – 97,569 = $ 2,431
Yd = $2,431 x 360 = 8.75%
$100,000 100
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).

Example:
Quote of 92-14 = 92 and 14/32; with a basis of $100,000
par value a change in price of 1% = $1000 with 1/32 =
$31.25.
Stripped Treasury securities
Several major brokerages have created an investment
vehicle from Treasury securities. They purchase these
securities, deposit them in a bank custody account and then
separate out each coupon payment and principal. Then a
receipt is issued to investors representing an ownership in
the account. In essence, the security is stripped.

Trademark zero-coupon - Treasury securities refer to the

firm they are associated with.
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. Treasury program issues these direct
obligations of the U.S. government, ending trademark
and generic receipts
•Treasury strips - zero-coupons or stripped Treasury
securities
•Treasury coupon strips – created from the future
coupon
•Treasury principal strips - created from the principal
payment at maturity
Federal agency securities
There are two categories of federal agency securities:

·Government-sponsored enterprises securities market

·Federally related institutions securities markets
Federally related institutions
securities
While a number of arms of the federal government are
allowed to issue securities directly in the marketplace,
only the Tennessee Valley Authority (TVA) has done so
recently. These issues are backed by the full faith and
credit of the U.S. government.
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, these are not backed by the
U.S. government.
Corporate bonds
The issuer agrees to make coupon payments and repay the principal
value of the bond at maturity. If the institution cannot pay, it is in
default. 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
Security for bonds
Beyond the general credit standing, real or personal
property may be pledged.

Insert Table 22-2

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.e. lower their debt costs) and call
provisions are an embedded option for the issuer.
Corporate bonds are usually callable at a premium above par
with the amount declining as the bond approaches maturity,
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, common stock sale proceeds).
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

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, which lowers the
bond value, the bondholder can put the bond to the issuer for par
Investor receives
1.Non-putable corporate bond and
2.Long put option on the bond
Floating-rate securities
Coupon interest is reset periodically based on some contrived
interest rate (i.e. spread over Treasury bill
Special features in high-yield bonds
High-yield or junk bonds have a rating below triple B. When used for
an LBO or recapitalization, where cash flow is severely restricted,
deferred coupon structures are created.
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
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.
Their structures are either serial maturity or term maturity.
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
General obligation bonds
Many general obligation bonds are secured by the issuer’s unlimited
taxing power.

Limited-tax general obligation bonds - 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, grants, etc. as

well as taxing power
Revenue bonds
These are bonds issued for project or enterprise financings where
the revenues from the project are promised to the bondholders.
Examples include airports, universities, sports complex bonds and
water revenue bonds.

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. or revenue bonds but are now secured by
an escrow fund consisting of U.S. government
obligations
Eurobonds
A Eurobond is
1.underwritten by an international syndicate
2.offered, at issuance, simultaneously to investors in a
number of countries
3.issued outside the jurisdiction of any single country
4.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.

Preferred stock
Preferred stock is not a debt instrument, but a senior security with
dividends set at a percentage of par value (dividend rate).
-Dividends are a distribution of earnings. However, 70% of
this income is exempt from federal taxation if the recipient is a
qualified corporation.
-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, the
dividend accrues until fully paid
Non-cumulative preferred – if issuer cannot make a payment,
owner forgos the payment
Perpetual preferred – issues without a maturity date
Mortgages and mortgage-backed
securities
Mortgage market is the largest sector of the fixed-income
market, and includes mortgage-backed securities such as
-Mortgage pass-through securities
-Collateralized mortgage obligations
-Stripped mortgage-backed securities
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. The lender
can foreclose on the borrower is the debt is paid.
Interest rate = mortgage rate

Conventional mortgage – loan is based on the credit of the

borrower and the collateral for the mortgage (a residence).
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.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.A repayment of a portion of the principal
The portion of the monthly payment applied to the interest declines
each month, while the payment towards principal increases. This
describes a self-amortizing loan.
Insert Table 22-4
 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.servicing fee
2.interest payment net of servicing fee
3.scheduled principal repayment
Prepayments and cash flow uncertainty
Loan holders can, and do, pay off mortgages early by making
prepayments (payments > scheduled payments) making cash flow
uncertain. This occurs when
-Homes are sold
-If market rates fall, there is incentive to pay off the higher
mortgage loan.
-Repossessed property
-Destroyed property: insurance pay off the mortgage
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, the prepayment speed is
variable.
Insert Figure 22-1
Insert Figure 22-2
Types of pass-throughs
Agency pass-throughs
-Government National Mortgage Association (Ginnie Mae)
-Federally related institution, so is based on full faith and credit of
U.S. government
-Federal Home Loan Mortgage Corporation (Freddie Mac)
-Federal National Mortgage Association (Fannie Mae)
Agency can guarantee two ways:
-Fully modified - timely payment of both interest and principal
-Modified - timely payment of interest only, with principal
payment simply guaranteed
Non-agency pass throughs
-Conventional pass throughs
-Private-label pass-throughs
Collateralized mortgage obligations
(CMO)
CMO - 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

Stripped mortgage-backed
securities
Instead of dividing the cash flow from the underlying pool
on a pro rata basis, stripped mortgage-backed securities
distribute the principal and interest unequally.
Principal and interest are divided between two classes
unequally.

Insert Figure 22-4

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.

Credit risk
In analyzing the risk of asset-backed securities we
focus on:
1.Credit rating of the collateral
2.Quality of the seller/servicer
3.Cash flow stress and payment structure
4.Legal structure
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. the reported
experience

Concentration risk – credit risk lessened by more borrowers in the pool

(diversification). Rating companies can set concentration limits on the
amount of receivables from any one borrower.
Credit enhancement – provides greater protection against losses due to
borrower defaults.
External – insurance, corporate guarantees, letters of credit, cash
collateral reserves
Internal – reserve funds, senior/subordinated debentures
Quality of the seller/servicer
Loan originator or financial institution establishes
underwriting standards, with the rating agencies
evaluating the servicer of the loans. Issues include
1.Servicing history
2.Experience
3.Originations
4.Servicing capabilities
5.Human resources
6.Financial condition
7.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.
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. If the issuer enters bankruptcy, the SPC will avert a
bankruptcy court consolidation of the collateral with the assets of
the seller.

SPC is a wholly-owned subsidiary of the seller of the collateral.

Collateral sold to SPC
SPC sells to the trust
Trust holds collateral for investors
SPC hold the interest retained by seller of collateral
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, residential)
Non-amortizing assets – no payment schedule; 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, 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
Credit card receivable-backed securities
Issued by
Banks, retailers, travel and entertainment companies
Cash flow
Net interest, principal, 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-amortization period - after lockout period (18 months – 10 years),

principal is paid to investors.

Early amortization – occurs if trust is not able to generate enough income to

cover coupon and fees, default of services, issuer violates pooling and servicing
agreements
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, 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, prepayments

Prepayments add uncertainty to the cash flow.

Manufactured housing-backed securities
Issued by Ginnie Mae and private entities, these securities are backed by
loans for manufactured homes (mobile homes).

Ginnie Mae loans are guaranteed by FHA or VA

Other issuers, such as Green Tree Financial, make conventional loans and
make conventional manufactured housing backed securities.
Loans last 15-20 years with fully amortized loan repayment.

Cash flow
Net interest, scheduled principal payments, prepayments

Prepayments are more stable since the loan balances are small, making
refinancing imprudent. Also, the rate of depreciation is high in the earlier
years making it harder to refinance the loan.