Providence College School of Business

FIN 417
Fixed Income Securities
Fall 2021
Instructor: Matthew Callahan
 Fixed Income Securities: Topic Outline
Fundamental Concepts of Fixed Income Securities

Fixed Income Asset Classes and Securities Valuation Techniques

Portfolio Techniques, Asset-Liability Management and Derivatives

- Asset Backed Securities and Structured Products (CMBS, CDO, Credit Cards)
- Bond Portfolio Strategies
- Asset-Liability Management: Banks, Pensions and Insurance

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 Introduction to Asset Backed Securities

Securitization: This process involves moving assets from the owner of

the assets into a special legal entity.
Asset-backed Securities: securities that are backed, or collateralized,
by a pool (collection) of assets, such as auto loans and credit card
receivables and sold to investors.

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 Introduction to Asset Backed Securities

Assets that are typically used to create asset-backed bonds are called
“securitized assets” and include the following, among others:

Residential mortgage Commercial mortgage Automobile loans

Home Equity Loans loans

Student loans Bank loans Credit card debt

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 Benefits of Asset Securitization
The securitization of pools of loans into multiple securities provides an economy
with a number of benefits:
• Allows investors to get a direct exposure to a portfolio of
mortgages or other receivables without having a bank as an
intermediary

• Allows banks to increase the amount of funds available to

lend and increase fee income

• Allows the creation of tradable securities with better liquidity

than the original loans on the bank’s balance sheet

• Enables innovations in investment products

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 Asset Securitization Process
The main two parties in securitization

Originator
• Originally owns the assets and sells
(seller of the them to the issuer (SPV)
collateral)

Special purpose • Creates a security backed by the assets

vehicle (SPV) and sells them to investors

The third parties in securitization

• Independent accountants,
Servicer (different lawyers/attorneys, trustees,
from the seller) underwriters, rating agencies, and
guarantors
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Asset Securitization Process

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 Non-agency Residential Mortgage-Backed Securities
Non-agency RMBS share many features and structuring techniques with
agency CMOs. However, two complementary mechanisms are usually required
in structuring non-agency RMBS.

1 The cash flows are distributed by rules, such as the

waterfall, that dictate the allocation of interest
payments and principal repayments to tranches
with various degrees of priority/seniority.

2 There are rules for the allocation of realized losses,

which specify that subordinated bond classes have
lower payment priority than senior classes.
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 Commercial Mortgage-Backed Securities (CMBS)
 Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial
mortgage loans on income-producing property.
 Commercial mortgage loans are non-recourse loans, and as a result, the lender can only
look to the income-producing property backing the loan for interest and principal
repayment.

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 Commercial Mortgage-Backed Securities (CMBS)
• Before the mid-1990s the U.S. real estate business was predominantly a private market.
• Lending was dominated by a handful of banks, life insurance companies, and pension funds.
• Real estate ownership was regionally focused, with ownership concentrated in a few hands. Families and private
partnerships were the largest owners.
• In the real estate recession of the late 1980s and early 1990s, commercial real estate prices fell by 50% or more in
some areas, and delinquency rates on loans soared to all-time highs.
• Losses led to the exit of many traditional lenders from the commercial mortgage market.
• Regulators and rating agencies turned more negative on commercial mortgage holdings, so that the remaining
lenders became less willing to extend credit.
• Low real estate values combined with the failure or exit of traditional lenders provided innovation opportunities and a
shift from private to public ownership.
• REITs began buying undervalued real estate portfolios funded through public stock and bond offerings. REIT
shares provided an opportunity for small, diversified investments in real estate.
• Investment banks started to apply securitization legal structures developed during the 1970s and 1980s for
residential mortgage-backed securities (RMBS) to commercial mortgages. In the mid- to late-1980s, issuers
securitized a few loans on single properties into CMBS.

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Real Estate Loan Originations (All Types)

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Commercial Mortgage-Backed Securities (CMBS)

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 Commercial Mortgage-Backed Securities (CMBS)
• CMBS have very simple structures compared to their residential mortgage counterparts.
• Each tranche represents a security with its own credit rating, average life, and other
characteristics.
• Bonds are almost always sequential pay: amortization, prepayments, and default
recoveries are paid to the most senior remaining class. The lowest-rated remaining
class absorbs losses.
• Unlike their residential counterparts, commercial mortgages almost always have
some form of prepayment penalty, making credit analysis more important than
prepayment analysis.
• A CMBS investment requires analysis on three levels: property, loan, and bond.

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 Commercial Mortgage-Backed Securities (CMBS)
Typical Structure for CMBS Deal:

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 Commercial Mortgage-Backed Securities (CMBS)
Commercial mortgage loans are non-recourse loans, and as a result, the lender can only
look to the income-producing property backing the loan for interest and principal
repayment.

Two measures of credit performance of CMBS:

Debt-to-service coverage ratio

(DSCR), which is the property’s net
Loan-to-value ratio (LVT)
operating income (NOI) divided by
the debt service

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 Commercial Mortgage-Backed Securities (CMBS)
Net Operating Income: Equals all revenue from the property minus all reasonably
necessary operating expenses. Aside from rent, a property might also generate revenue
from parking and service fees, like vending and laundry machines. 

Operating Expenses: are those required to run and maintain the building and its
grounds, such as insurance, property management fees, utilities, property taxes, repairs and
janitorial fees.

NOI is a before-tax figure; it also excludes principal and interest payments on

loans, capital expenditures, depreciation and amortization.

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Commercial Mortgage-Backed Securities (CMBS)

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Commercial Mortgage-Backed Securities (CMBS)

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 Commercial Mortgage-Backed Securities (CMBS)
Case Study: 200 Park Avenue New York, NY

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CMBS Case Study: 200 Park Avenue

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CMBS Case Study: 200 Park Avenue

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CMBS Case Study: 200 Park Avenue

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CMBS Case Study: 200 Park Avenue

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CMBS Case Study: 200 Park Avenue

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CMBS Case Study: 200 Park Avenue

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 Non-Mortgage Asset-Backed Securities

The collateral for an asset-backed security can be either:

Amortizing assets
(e.g., auto loans, personal and or
commercial loans)
In amortizing structures, the
principal received from the
scheduled repayment and any
prepayments are distributed to
the bond classes on the basis of
the waterfall.
Non-amortizing assets
(e.g., credit card receivables)
For non-amortizing assets,
prepayments by borrowers do not
apply since there is no schedule
of principal repayments.
In non-amortizing structures,
typically there is a lockout period,
a period where principal
repayments are reinvested in
new assets.
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 Auto Loan Backed Securities
Auto loan- The cash flows for auto loan-backed securities
backed consist of regularly scheduled monthly loan
securities payments (interest payment and scheduled
principal repayments) and any prepayments.

All auto loan-backed securities have some form of

credit enhancement—often a senior/ subordinated
so the senior tranches have credit enhancement
because of the presence of subordinated tranches.

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 Credit Card Backed Securities

Credit card For a pool of credit card receivables, the cash

receivable- flows consist of finance charges collected, fees,
backed and principal repayments.
securities
Interest—fixed or floating—is paid to security
holders periodically.

Credit card receivable-backed securities have

lockout periods during which the cash flow that is
paid out to security holders is based only on
finance charges collected and fees. When the
lockout period is over, the principal is no longer
reinvested but paid to investors.
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 Fixed Income Portfolio Techniques and Strategies
Generally speaking, there are two major types of investor categories for
establishing Fixed Income Portfolio Management Strategies:

 The investor does not have a specific liability that needs to be match.
- Often will have a specific benchmark return to meet or outperform.
- Can be active or passive investment management style.
 The investor does have a specific liability (or set of liabilities) that needs to be matched.

- Liabilities can be in the form of pension, insurance or time dependent cash

needs.

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 Fixed Income Portfolio Techniques and Strategies
Five Major Strategies for Managing Fixed Income Portfolio Against a
Bond Market Index:

The styles range from totally passive to full-blown active management.

 Passive Management: Assumes that market efficiency is high and that investors
cannot add meaningful value after all expenses are included. Managers try to mimic
index and closely track its performance.
 Active Management: Relies on portfolio manager’s skill to exploit opportunities in the
market and increase the portfolio’s return relative to the benchmark.

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 Fixed Income Portfolio Techniques and Strategies
Three Passive Management Styles:
Pure Bond Indexing (Full Replication Approach)
- Approach attempts to duplicate index by owning all the bonds in the index in
the same percentages.
- Many bonds in typical index are illiquid and thinly traded.
- Difficult and expensive to implement.
- Much less common approach than in equities where it is much easier to implement.

Enhanced Indexing by Matching Primary Risk Factors

- Style uses a sampling approach to match the primary risk factors in a benchmark.
- Primary Risk Factors: changes in the level of interest rates, twists in the yield
curve, sector allocations and changes in the spread between Treasuries and non-Treasuries.
- Less expensive than full replication of index.

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 Fixed Income Portfolio Techniques and Strategies
Enhanced Indexing by Small Risk Factor Mismatches
- Style typically matches duration of index while altering other risk factors to achieve
superior returns relative to index.
- Manager may attempt to increase returns by pursuing relative value in certain sectors,
credit quality, term structure etc.

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 Fixed Income Portfolio Techniques and Strategies
Two Active Management Styles:
Active Management by Larger Risk Factor Mismatches
- Style relies on readiness to make deliberately larger mismatches on primary risk factors.
- Actively pursue opportunities in the market when they arise.
- Examples: Overweight corporates vs treasuries, duration mismatch, yield curve exposure.
- Need to generate sufficient returns to overcome expense and risk.

Full Blown Active Management

- Style uses aggressive mismatches versus index.
- Benchmark can be bond index or hurdle rate (Libor).
- Aggressive mismatches on duration, sectors, credit risk, liquidity etc.
- Often used by Fixed Income Hedge fund managers.

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 Fixed Income Portfolio Techniques and Strategies
Common Bond Indexes:
Global
 (Bank of America) Merrill Lynch Global Bond Index
 Bloomberg/Barclays Capital Aggregate Bond Index
 Citi World Broad Investment-Grade Bond Index (WorldBIG)

U.S. Bonds
 (Bank of America) Merrill Lynch US Broad Market Index
 Bloomberg/Barclays US Aggregate Bond Index
 Citi US Broad Investment-Grade Bond Index (USBIG)

Emerging Market Bonds

 J.P. Morgan Emerging Markets Bond Index
 Citi Emerging Markets Broad Bond Index (EMUSDBBI)

High-Yield Bonds
 (Bank of America) Merrill Lynch High-Yield Master II
 Bloomberg/Barclays High-Yield Index

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 Fixed Income Portfolio Techniques and Strategies
Composition of an Bank of America/Merrill Lynch US Broad Market Index:

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 Fixed Income Portfolio Techniques and Strategies
Many bond indices are not easily replicated and investable and, therefore, are not suitable to
serve as benchmarks.
Compared with equities, most bond issues also have less-
active secondary markets.
Because of the heterogeneity of bonds, bond indices that
appear similar can often have very different composition
and performance.

The index composition tends to change frequently.

The “bums” problem arises when capitalization-weighted bond

indices give more weight to issuers that borrow the most (the
“bums”).
Investors may not be able to find a bond index with risk
characteristics that match their portfolio’s exposure.

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 Fixed Income Portfolio Techniques and Strategies
Managing Fixed Income Portfolios Against Liabilities:

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 Fixed Income Portfolio Techniques and Strategies
Dedication: Strategy often used by pension funds, banks and insurance companies to
match bond portfolio assets with liabilities.

Types of Liabilities

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 Fixed Income Portfolio Techniques and Strategies
Dedication: Cash Flow Matching Strategies which are designed to exactly (or closely)
match the cash flows of the assets with those of the liabilities.

Conceptually, a bond is selected with a maturity that

matches the last liability, and an amount of principal equal
to the amount of the last liability minus the final coupon
payment is invested in this bond.

The remaining elements of the liability stream are then

reduced by the coupon payments on this bond, and another
bond is chosen for the next-to-last liability, adjusted for any
coupon payments received on the first bond selected.

This sequence is continued until all liabilities have been

matched by payments on the securities selected for the
portfolio.

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 Fixed Income Portfolio Techniques and Strategies
Cash Flow Matching Strategies:
• If all the liability flows were perfectly matched by the asset flows of the portfolio,
the resulting portfolio would have no reinvestment risk and, therefore, no
immunization or cash flow match risk.
• Given typical liability schedules and bonds available for cash flow matching;
however, perfect matching is unlikely.

Under such conditions, a minimum immunization risk approach should

be as good as cash flow matching and likely will be better because an
immunization strategy would require less money to fund liabilities.

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 Immunization
Classical immunization can be defined as the creation of
a fixed-income portfolio that produces an assured return for
a specific time horizon, irrespective of any parallel shifts in
the yield curve.

Setting the duration of the portfolio equal to the specified

portfolio time horizon (duration matching) assures the
offsetting of positive and negative incremental return
sources under certain assumptions, including the
assumption that the immunizing portfolio has the same
present value as the liability being immunized.

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DEDICATION STRATEGIES: IMMUNIZATION

• An immunization strategy should be dynamic (through

rebalancing) because the duration of the portfolio changes as the
market yield changes and with the passage of time.
• In the immunization strategy, the investor’s goal might be to
reestablish the dollar duration of a portfolio to a desired level.

Dollar Duratio Portfolio

0.01
duration n value

• A portfolio’s dollar duration is equal to the sum of the dollar

durations of the component securities.
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 DEDICATION STRATEGIES: IMMUNIZATION

This rebalancing involves the following steps:

1
Move forward in time and include a shift in the yield curve. Using
the new market values and durations, calculate the dollar duration
of the portfolio at this point in time.

2 Calculate the rebalancing ratio by dividing the desired dollar

duration by the new dollar duration. If we subtract one from this
ratio and convert the result to a percent, it tells us the percentage
amount that each position needs to be changed in order to
rebalance the portfolio.
3
Multiply the new market value of the portfolio by the desired
percentage change in Step 2. This number is the amount of cash
needed for rebalancing.
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 DEDICATION STRATEGIES: IMMUNIZATION
Rebalancing based on the dollar duration:
Example. The initial portfolio of three bonds with $1 million par value
each had a dollar duration of $111,945. After a shift in the interest rate,
the portfolio values are as follows:
Security Price Market Value Duration Dollar Duration
Bond A $99.822 $1,023,704 4.246 $43,466
Bond B 98.728 1,004,770 0.305 3,065
Bond C 99.840 1,002,458 3.596 36,048
$82,579

• Calculate the rebalancing ratio and cash required for rebalancing

to maintain dollar duration at the initial level.
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 DEDICATION STRATEGIES: IMMUNIZATION

Example (continued).

1) To calculate the rebalancing ratio:

• Rebalancing requires each position to be increased by 35.6%.

2) To calculate the cash required for this rebalancing:

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DEDICATION STRATEGIES: IMMUNIZATION

• Spread duration is a measure of how the

market value of a risky bond (portfolio) will
change with respect to a parallel 100 bp
change in its spread above the comparable
Spread benchmark security (portfolio).
duration • It is an important measurement tool for the
management of spread risk.
• Spreads do change, and the portfolio
manager needs to know the risks associated
with such changes.

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 EXTENSIONS OF CLASSICAL
IMMUNIZATION THEORY
There are a few extensions to classical immunization theory:

Extend to the case of nonparallel shifts in interest rates: Use key

rate duration, or develop a strategy that can handle interest rate
changes without specifying duration.

Overcome limitations of a fixed horizon.

Analyze the risk and return trade-off for immunized portfolios.

Integrate immunization strategies with elements of active bond

portfolio management strategies. One strategy is called
“contingent immunization,” which provides a degree of
flexibility in pursuing active strategies while ensuring a certain
minimum return in the case of a parallel rate shift.
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 EXTENSIONS OF CLASSICAL
IMMUNIZATION THEORY
• With changes in the market, the portfolio manager faces
the risk of not being able to pay liabilities when they come
due.
Three sources of this risk:
Contingent
Interest rate risk Cap risk
claim risk

The prices of most fixed- The manager is

When a security
income securities move at risk of the
has a contingent
opposite to interest rates, level of market
claim provision,
and a rising interest rate rates rising
explicit or
environment will while the
implicit, there is
adversely affect the value floating-rate
an associated
of a portfolio. asset returns are
risk.
capped.
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 EXTENSIONS OF CLASSICAL
IMMUNIZATION THEORY
• Immunization with respect to a single investment horizon
is appropriate where the objective of the investment is to
preserve the value of the investment at the horizon date.
This objective is appropriate given that a single liability is
payable at the horizon date.

• For multiple liabilities, there must be enough funds to pay

all the liabilities when due, even if interest rates change by
a parallel shift.

Matching the duration of the portfolio to the average duration of

the liabilities is not a sufficient condition for immunization in
the presence of multiple liabilities.
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 MULTIPLE LIABILITY IMMUNIZATION

• The necessary and sufficient conditions to assure multiple

liability immunization in the case of parallel rate shifts:

The present value of the assets equals the present value of

the liabilities.

The duration of the portfolio must equal the duration

of the liabilities.

The distribution of durations of individual portfolio assets

must have a wider range than the distribution of the
liabilities.

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IMMUNIZATION FOR GENERAL CASH FLOWS

• In both the single investment horizon and multiple liability

cases, the assumption is that the investment funds are
initially available in full. This is not always the case.
• A strategy can be constructed to deal with this issue:

The expected cash contributions can be considered the

payments on hypothetical securities that are part of the initial
holdings. The actual initial investment can then be invested in
such a way that the real and hypothetical holdings taken
together represent an immunized portfolio.

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 RETURN MAXIMIZATION FOR
IMMUNIZED PORTFOLIOS
• The objective of risk minimization for an immunized
portfolio may be too restrictive in certain situations.
• If a substantial increase in the expected return can be
accomplished with little effect on immunization risk, the
higher-yielding portfolio may be preferred in spite of its
higher risk.
• The required terminal value, plus a safety margin in money
terms, will determine the minimum acceptable return over
the horizon period.
The difference between the minimum acceptable return and the
higher possible immunized rate is known as the cushion
spread.
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