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141 Cards in this Set
- Front
- Back
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Default risk
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The risk that an issue will default on its obligation
A lower credit rating, the higher the probability of default |
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Credit spread risk
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the risk of an increase in spread, which suggests the issue is at higher risk of default (or simply adverse or inferior performance)
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Downgrade risk
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the risk that an issue with be downgraded by a rating agency
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Capacity
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The ability of the issuer to repay its obligations
Will also factor in industry trends, the regulatory environment, basic operating and competitive position, financial position and sources of liquidity, company structure, parent company support agreements, and special event risk |
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Collateral
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assets pledged to secure the debt, but also to the quality and value of those un-pledged assets controlled by the issuer (potential aid)
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Covenants
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the terms and conditions of the lending arrangements (limitations and restrictions of management’s discretion, all to help minimize risk to the creditors)
provide insight into corporate strategy, loopholes may uncover management’s intentions |
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Affirmative covenants
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(require the borrower to TAKE certain actions): to pay obligations on a timely basis, to pay all taxes and claims when due unless contested in good faith, maintain all properties used and useful in good condition, submit periodic certificates to the trustee stating whether the debtor is in compliance
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Negative covenants
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(require the borrow to NOT take certain actions): limitations on the borrower’s ability to incur more debt (might be an absolute or a ratio limit like debt to cap), maintenance tests to meet certain coverage ratio requirements, and a debt incurrence test required if the issuer wishes to take on additional borrowings
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Character
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Ethical reputation, business qualifications and operating record of the board of directors, management and executives responsible for the use and repayment of those funds
Rating agencies evaluate the following factors: strategic direction, financial philosophy, conservatism, track record, succession planning, control systems |
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Components of credit analysis
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Capacity, Collateral, Covenants, and Character
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Key financial ratios for credit analysis
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Profitability ratios: return on stockholder’s equity, return on total assets, profit margin, asset turnover
Debt and coverage ratios: short-term solvency ratios – to judge the adequacy of liquid assets for meeting short-term obligations as they come due Capitalization (or financial leverage) ratios: determines to what extent the company uses financial leverage – financial leverage ratios: higher if the industry is stable and CFs reliable Coverage ratios: test the adequacy of CFs generated through earnings for purposes of meeting debt and lease obligations |
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Operating cycle
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the duration from the time cash is invested in goods and services to the time that investment produces cash; the longer the operating cycle the higher your current ratio should be to cover short-term obligations
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Risks that encompass the likelihood of default
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information risk (where the available information to evaluate default risk is not credible)
agency risk (the risk that management will make decisions in its own self-interest, reducing the firm value) |
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Why and how cash flow from operations is used to assess the ability of an issuer to service its debt obligations and to assess the financial flexibility of a company?
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Access to external cash to cover temporary shortfalls - investment grade companies are much better positioned, compared to junk-bond issuers, who lack this degree of flexibility and have fewer alternatives to internally generated cash for servicing debt
From CFFO, can determine whether a company’s source of financing is internally or externally generated, the ability of the company to meet debt obligations (interest + principal), the ability to finance expense through CFFO, the ability to pay dividends, and the financing flexibility |
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Bank debt
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holders of bank debt have priority over other debt holders, it is typically short-term (around 2 years) – consider repayment sources: (operating CF, refinancing, and sale of assets), and the rate often floats (interest rate risk)
If short-term funds are needed and bank loans are not available, broker loans (or bridge loans), or reset notes (where the coupon rate is reset periodically) |
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Senior bonds
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typically longer term; deferred coupon bond (defer interest payments until a point in the future) – troubling as this reduces operating CF via additional interest expense
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Senior-subordinate and Subordinate (of payment in kind: PIK)
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occurs when another bond with the same coupon rate can be used to pay interest – again increasing interest expense
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Corporate structure
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determine how the cash flows between subsidiaries and the parent company, and whether subsidiary CFs can compensate for parent CF shortfalls, or vice versa
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Credit quality of the collateral - a factor considered by credit rating agencies
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the underlying borrower’s ability to pay and the borrower’s equity in the asset; concentration of loans (a risk if there are few borrowers in a pool, lose benefits of diversification); necessary credit enhancements: internal (reserve funds, overcollateralization, and senior/subordinated structures) or external (insurance, corporate guarantees, letters of credit, or cash collateral reserves)
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Quality of the seller/servicer - a factor considered by credit rating agencies
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servicing involves the collecting of payments from borrowers, notifying delinquent borrowers, and dealing with collateral if default occurs
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Cash flow stress and payment structure - a factor considered by credit rating agencies
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how cash flows are distributed to pay trustee fees, servicing fees, other admin fees, and interest and principal to bondholders; rating agencies go through a scenario analysis to determine what loss to different bonds could occur
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Legal structure - a factor considered by credit rating agencies
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corporations using structured finance wants ratings on the issued securities to be better than its own corporate bond rating, if not better to just issue corporate bonds;
SPVs are created for this purpose of protecting collateral of the selling corporation from the reach of bankruptcy proceedings – SPV is the issuer |
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Tax-backed debt: four categories to do analysis on
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i. Issuer’s debt structure (determine overall debt burden)
ii. Issuer’s ability and political discipline to maintain sound budgetary policy iii. Specific local taxes and intergovernmental revenues available to the issuer (and historical tax info to determine property tax levies, dependence on the budget for specific rev sources) iv. An assessment of the issuer’s overall socioeconomic environment (employment, etc) |
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Revenue bonds
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either project or enterprise financing:
Determine whether the project being financed will generate sufficient cash flows to satisfy obligations due to bondholder Limits of basic security, the flow of funds structure (how CF flows from project to debt holders), the rate/user-charge covenant (dictates how charges will be set on the product or service sold by the enterprise), the priority of revenue claims (if lenders can tap the revenue of the issuer before the flow of funds structure is underway), the additional bonds test (can multiple bonds have the same lien, and other relevant covenants (often issuer pledges, insurance requirements, reporting requirements, |
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Considerations used by S&P in assigning sovereign ratings
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Economic risk – the ability of the government to satisfy obligations
Political risk – the willingness of the government to pay, regardless of its ability to pay |
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Why two ratings are assigned to each national government
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Two ratings are assigned – local currency debt and foreign currency debt, because a government can raise taxes to satisfy local obligations, but this is not the case with foreign currency debt
For local currency debt: looking for stability of political institutions and degree of popular participation in the political process (do people pay taxes), income and economic structure, fiscal policy and budgetary flexibility, monetary policy and inflation pressures, public debt burden and debt service track record For foreign currency debt: looking at the interaction of domestic and foreign government policies, the country’s balance of payments and the structure of its external BS; net public debt, total net external debt, and net external liabilities |
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Credit analysis required for corporate bonds vs. asset-backed securities:
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there is no operation or business risks as there are in corporate bonds, the quality of the collateral in generating the CF needed to pay obligations; greater visibility into CFs due to no operational risks
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Credit analysis required for corporate bonds vs. municipal securities:
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similar analysis as character of public officials is similar to analyzing the character of management, municipalities are similar to corporations in that operations (employment) are a key component to analyze
covenants specific to municipal securities include rate covenants and priority of revenue covenants that specific if other parties can legally tap the revenue of the enterprise before the revenue can be passed to bondholders |
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Credit analysis required for corporate bonds vs. sovereign debt:
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again similar to corporate in that you’re analyzing a country vs. a corporation
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Normal yield curve
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positively sloped – rewards investors for holding longer maturity treasuries with a higher yield
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Flat yield curve
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all maturities have equal yields
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Inverted yield curve
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negatively sloped – longer the maturity, the lower the yield
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Humped yield curve
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increasing with maturity for a range of maturities and then the yield curve becoming inverted
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Steepness/slope of the yield curve
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refers to the difference between long-term and short-term treasury yields
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Yield curve shifts
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refer to the relative change in yield for each Treasury maturity
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Parallel shift
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refers to a shift in which the change in the yield for all maturities is the same
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Non-parallel shifts - twist
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the flattening or steepening of the yield curve, with flattening diminishing the slop of the spread between long-term and short-term treasury
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Non-parallel shifts - change in curvature
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Positive butterfly: the yields in the short maturity and the long maturity increase more than the yields in the intermediate maturity
Negative butterfly: when yields in the intermediate maturity decrease less than the short and long maturities Yields in the short-term tend to be more volatile than yields in the long-term sector |
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Factors that drive US Treasury security returns
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Changes in the level of rates – greatest explanatory power for all the maturities with R^2 of 90%
Changes in the slope of the yield curve – second best in terms of explanatory power at 8.5% Changes in the curvature of the yield curve – relatively little contribution to explanatory power |
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Treasury coupon strips - advantages and disadvantages
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Advantages – simplest to use? Just use the observed yield to construct the spot rate curve
Disadvantages – but not as straightforward: 1) liquidity of the strips market is not as great as the coupon market (so observed yields reflected a premium for liquidity); 2) tax treatment of strips differ from coupon securities (accrued interest on strips is taxed despite no cash outflow; 3) some non-US investors find the trade-off yield for tax advantages associated with the strip to be advantageous, as they are able to treat the difference between the maturity value and the purchase price as a capital gain, a favorable tax rate – but often restricted by strips only created from the principal rather than the coupon |
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On-the-run treasury issues
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most recently auctioned issues of a given maturity – 1,3, 6-month treasury bills (zero-coupon instruments) and 2, 5, 10-yr notes (coupon securities); yield curve is called the par coupon curve, as the yield necessary to make the issue trade at par is used (eliminates tax treatment issues)
Bootstrapping is used Disadvantage: large gap between maturities, especially after five years |
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On-the-run treasury issues + selected off-the-run treasury issues
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Bootstrapping is used to construct the theoretical spot rate curve
Advantages – fills in the maturity gaps Disadvantages – fails to recognize the information embodied in treasury prices |
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All treasury coupon securities and bills
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Advantages – attempts to capture all available information in theoretical spot rate curve
Disadvantages – more complex methods beyond bootstrapping often need to be employed – fitting the curve, adjusting for the effect of taxes |
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Swap rate curve
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provides swap rates by maturities, the swap spread is the most common way to quote a swap rate for a given maturity over a desire benchmark, often the gov’t bond yield – is essentially reflecting the credit risk between the swap rate and the default free rate
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Swap rate curve advantages over a gov’t bond yield curve as a benchmark
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No governmental regulation (to any major degree) of the swap market (gov’t regulation would involve taxes into the equation making comparables difficult
Supply of swaps depends only on the # of counter-parties looking to enter a swap transaction Comparisons across countries of government yield curves is difficult due to sovereign credit risk More maturity points to construct a swap curve vs. gov’t bond maturity |
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Pure expectations theory
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Forward rates exclusively represent expected future spot rates
Suggests that a rising term structure must indicate that the market expects short-term rates to rise throughout the relevant future; Fails to address the risks inherent in investing in bonds (if forward rates were prefect predictors of future interest rates then the future prices of bonds would be known with certainty) Main risks include: a. Uncertainty about the price of the bond at the end of the investment horizon – if you invest in a 12 year bond but plan to sell it in five years – you have no certainly of what the yield on the 7-yr bond will be 5 years from now and the longer the maturity, the greater the interest rate risks (reinvestment risk) Broadest interpretation of this theory, is that investors expect the return to be the same for any investment horizon, and regardless of the maturity Local expectations interpretation – that the return will be the same over a short-term investment horizon stating today, regardless of the maturity Forward rates are important, because they are used to predict future interest rates, but often are more of an indication of how investor’s expectations must differ from the break-even rates or the lock-in rate when making an investment decision |
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Reinvestment risk
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whether proceeds from the bond at maturity can be reinvested at similar rates, at that time, is unknown
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Local expectations interpretation of pure expectations theory
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that the return will be the same over a short-term investment horizon stating today, regardless of the maturity
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Liquidity theory
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that forward rates should reflect both interest rate expectations and a “liquidity” premium (or risk premium), which should be higher for longer-term maturities
Ascertains that forward rates will NOT be an unbiased estimate of the market’s expectations of future interest rates because they contain a liquidity premium |
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Preferred habitats theory
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also says that the term structure should reflect the expectation of the future path of interest rates + risk premium – but rejects the assumption that the risk premium should rise uniformly with maturity – this could only be true if investors plan to liquidate their investments at the shortest possible date and that there is always a borrower anxious to go long
Asserts that if there is an imbalance between the supply and demand for funds within a given maturity, buys and sellers are less likely to shift from their preferred habitat or current investment – there would need to be a yield premium to entice them Shape of the yield curve is explained by the biased expectations theory: liquidity and preferred habitats theory |
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Yield curve risk
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the exposure of a portfolio or position to a change in the term structure; its sensitivity to a change in the spot rate for a key maturity, while the spot rate for the other key maturities remain constant
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Key rate duration
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breaks up the impact of rate sensitivity/rate duration into parts, or key maturities and measures the impact
If you have a portfolio of three maturities, key rate duration = the weighted average of maturities and their respective key rate duration to determine total portfolio duration Apply the proposed changes in rate (up or down) * the maturity or portfolio duration (depending on the specifics of the rate change) to find the % change in portfolio value (sum of all % changes, if need be) |
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Ladder portfolio
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pretty even weights in each maturity
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Barbell portfolio
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more weighted towards the short and long-term bonds than the intermediate maturity bonds
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Bullet portfolio
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heavily weighted towards one maturity compared to the other
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Yield volatility
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effective duration alone is not sufficient to measure interest rate risk, must also consider yield volatility – measures the change in daily yield relative to the previous day’s yield
Volatility is measured in standard deviation or variance To compute yield volatility, find the sd or variance of Xt(s) = 100 * (LN (yt/yt-1)) where yt is the yield on day t and yt-1 is the yield on day t-1; Xt is the % change in yield |
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Historical volatility
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is found by estimating historical yield volatility from past results
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Implied volatility
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estimating yield volatility based on the observed prices of interest rate options and caps;
Problems include: 1) assumes the option pricing model is correct; 2) assumes volatility is constant over the life of the option |
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Forecasting yield volatility
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Determine what mean value should be used in the calculation of forecasted standard deviation, or use zero as the expected value of the change in yield and apply the following formula to determine variance
Sum of weighted Xts squared / (t – 1), where Xt is the daily % yield change Periods of volatility are often followed by more volatility; stable periods are also persistent – suggests that volatility can be modeled after recent, past results |
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Evaluating relative value of a "security" OAS
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If computed or “security” OAS is greater than what the market requires for credit risk and liquidity risk, or the “required OAS” then the security is undervalued
If computed or “security” OAS is less than what the market requires for credit risk and liquidity risk, or the “required OAS” then the security is overvalued Must use the OAS, as the zero volatility spread and nominal spread marks the compensation for the embedded option If OAS is zero or negative against the treasury market or the bond sector with a given credit rating, the security is “rich”; if OAS is positive, the security is potentially cheap, but a comparison must be made between the security OAS being valued and the required OAS Security OAS must be > than the Required OAS |
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Nominal spread
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from the treasury yield curve, reflects compensation for credit risk, option risk, liquidity risk
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Zero volatility spread
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is the static spread from the treasury spot rate curve that when added to all of the spot rates will make the PV of the bond’s cash flow equal to the bond’s market price
Reflects compensation for credit risk, option risk, liquidity risk |
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Option adjusted spread
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is when a bond has an embedded option, and you remove the portion of the yield that is attributable to that option, to get the OAS
Reflects compensation for credit risk and liquidity risk |
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What is the importance of benchmark interest rates in interpreting spread measures
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Benchmark interest rates can be based on either:
i. an estimated yield curve – relationship between yield and maturity for coupon bonds ii. an estimated spot rate curve – relationship between spot rates and maturity Benchmark interest rates set the basis for the spread calculation could be: i. the Treasury market (use the treasury yield of spot curve) ii. a specific bond sector with a given credit rating: i.e. single A rated corporate bonds or double-A rated banks; the LIBOR curve (as an inter-bank, or AA rated benchmark) – (use the sector yield or spot curve) iii. a specific issuer (use either the issuer yield or spot rate curve) – for nominal + the yield curve there is only option risk and liquidity risk; for zero-volatility +spot rate curve there is option risk and liquidity risk, and for option-adjust + spot rate curve, there is just liquidity risk NO CREDIT RISK FOR A SPECIFIC ISSUER Under a specific issuer (with no credit risk); negative OAS = overvalued security and positive OAS means an undervalued security |
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Backward induction valuation methodology within the binomial interest rate tree framework
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At each node of the interest rate tree the decision will be whether or not the issuer or bondholders (depending on the type of embedded option) will exercise the option
In the binomial model the assumption is that there are only two options and that each option is equally weighted Back induction valuation says that if we are at some node, then the value at that node will depend on the future cash flows, and future cash flows depend on the coupon payment one year from now and the bond’s value one year from now The value at each node is the PV of expected cash flows; multiplied by the “weight/probability” Value at each node = ½ * <(Vh + C)/(1 + r) + (VL + C)/(1 + r)> based on the previous two nodes, as you work through to the base of the binomial interest rate tree |
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Effect of volatility on the arbitrage-free value of an option
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The higher the expected volatility, the higher the value of an option (same goes for an option embedded in a bond)
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Interpret an option-adjusted spread with respect to a nominal spread and to benchmark interest rates
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an OAS is the constant spread that when added to all the 1-yr rates on the binomial interst rate tree will make the arbitrage-free value equal to the market price
OAS is dependent on volatility assumptions – the higher the volatility the smaller OAS (potentially negative) will become; if it becomes negative, the bond is overvalue relative to the model |
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Duration
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is the approximate % change in the value of a security for a 100bps change in interest rates
= (V when yield decreases - V when yield increases)/(2 * Vo * chg in rate used to calc new Vs) |
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Modified duration and convexity
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do not allow for the fat that the CFs for a bond with an embedded option may change due to the exercise of the option vs. effective duration and convexity which do take into account those changes
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Convexity
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= (V when yield decreases - V when yield increases – 2*Vinitial) / (2 * Vo * chg in rate used to calc new Vs)^squared
Convexity can be negative… |
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Step up callable notes
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are callable instruments whose coupon rate increases at designated times – to value just adjust the payments to the corresponding rates dependent on when the step up occurs through the binomial tree
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Valuing a capped floater, is different from a callable bond
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the coupon rate is set at the beginning of the period, but paid at the end of the period (or beginning of the next period) - the higher the cap, the closer the capped floater will trade to par
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a Cap - definition/purpose
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restricts the coupon rate to a certain level, so if the node surpasses that level at a given time, it will revert to the cap rate
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Convertible bond
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a security that can be converted into common stock at the option of the investor – or simply, a bond with an embedded option where the option is granted to the investor; callable and putable cause the following factors to matter:
Interest rate changes and their impact on the value of the bond (which also impact the call and put option) How changes in the stock price impacts the value of the option, to convert to common stock Most are callable, but may have a no-call period Some are putable – put options can be considered “hard” where the convertible security must be redeemed by the issuer for cash, or a “soft” put where the issuer has the option to pay in either cash, stock, or subordinate notes (or the combination of all three) |
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Convertible bond vs. ownership of the underlying common stock - the difference in risk-return characteristics between the two
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An investor would pay a premium for convertible bond – a premium to the current stock price – because the original conversion price based on the straight value of the embedded bond, acts as a floor, but this floor moves with interest rates
Downside risk is therefore the difference between the convertible bond’s price and the straight value with the straight value exposed to interest rate changes and the issuer’s credit quality Higher current income with the convertible bond (often the case) vs. the stock (with a dividend) Can compute how long the premium per share takes to recover with the coupon from the bond |
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Premium payback period:
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=market conversion premium per share / favorable income differential per share
Does not take into account the time value of money or changes to the dividend |
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Favorable income differential per share
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= <(coupon interest – (conversion ratio * common stock dividend per share)> / conversion ratio
i. Premium over straight value = market price of convertible bond/straight value - 1 ii. Upside potential depends on the prospects for the underlying stock iii. Busted convertible – when the stock price is below the conversion price iv. Convertible security = straight value + the value of the call option on the stock v. Convertible bond value = straight value + the value of the call option on the stock – value of the call option on the bond + the value of the put option on the bond |
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Busted convertible
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when the stock price is below the conversion price
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Convertible bond value
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straight value + the value of the call option on the stock – value of the call option on the bond + the value of the put option on the bond
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Mortgage loan
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is a loan secured by the collateral of some specified real estate property which obligates the borrower to may predetermined payments – the lender has the right to foreclose on the borrower in defaults and seize the property to pay down the debt
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Types of mortgage loans:
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Fixed rated level payments
Adjustable rate mortgages Balloon mortgages Growing equity mortgages Reverse mortgages Tiered payment mortgages |
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Fixed-rate level payment, fully amortizing mortgage loan structure:
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The mortgage rate is fixed for the life of the mortgage loan
The dollar amount of each monthly payment is the same for the life of the mortgage loan When the last scheduled monthly mortgage payment is made, the remaining mortgage balance is zero (fully amortized) The monthly mortgage payment consists of interest of: a. 1/12th the fixed annual interest rate times the amount of outstanding mortgage balance at the beginning of the previous month + a repayment of a portion of the outstanding mortgage balance (principal) b. Servicing fee is the bps between the rate paid by the borrower and the rate received by the investor c. Prepayment uncertainty – the risk that the homeowner pays down principal faster – reducing total value in terms of the interest component (some penalties exist) |
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Mortgage pass-through security
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when one or more holders of mortgages form a collection (pool) of mortgages and sell shares or participation certificates in the pool; when a mortgage is included in a pool of mortgages that is used as collateral for a mortgage pass-through security, the mortgage is said to be securitized
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Payment characteristics of a mortgage pass-through security
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monthly cash flow for a pass-through is less than the monthly cash flow of the underlying pool of mortgages by an amount equal to servicing and other (guarantee) fees; timing of payments is also delayed as actual individual mortgage payments go through the “middle man” first and then are distributed; rate varies across different mortgages – take the weighted average; the same for weighted average maturity in terms of months remaining
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Types of mortgage pass-through securities
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three are guaranteed by the US gov’t: Fannie Mae, Ginnie Mae, and Freddie Mac – FMs are “agencies” or specifically corporate instrumentalities of the US gov’t, while GM is a federally rated institution – conforming must remain within the US gov’t underwriting standards, or non-conforming, which is privately issued by thrifts, commercial banks, and private conduits
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Agency pass-through securities
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securities are identified by a pool prefix and pool number for trading:
dollar price paid for just the principal = price * par value * pool factor Risks: contraction and extension risks – not knowing the extent of prepayment until actual payments are made – low rates incentivize prepayment, which then gives CFs back to the investors when rates (aka returns) are lower |
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Single monthly mortality rate (SMM)
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the % amount of prepayment for any given month
SMM = prepayment in month t / (Beg mortgage balance for month t – scheduled principal payment for month t) Calc prepayment w/ SMM = SMM * (Beg mortgage balance for month t – scheduled principal payment for month t) |
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Conditional prepayment rate (CPR)
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annualized version of SMM
= 1 – (1 – SMM)^12 tells you what % of the mortgage will be pre-paid by the end of the year Can also use to find SMM = 1 – (1 – CPR)^(1/12) |
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Public Securities Association (PSA)
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looks at the pattern of prepayments over the life of a typical mortgage pool, and established a prepayment benchmark, or “prepayment model”
assumes that prepayment rates are low for newly originated mortgages and then speed up as they season Assumes a 0.2% CPR in the first month that increases by 0.2% per year, per month for the next 30 months until it reaches 6% per year, and then remains 6% CPR for the remaining months If t < 30 then CPR = 6%*(t/30) –or— if t >or equal to 30 then CPR = 6% 50 PSA or 100 PSA refers to what % of CPR, 50 PSA would be ½ CPR – 0 PSA would be no prepayment expected, but does not mean no principal repayments |
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Importance of average life of a mortgage-backed security
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average life of a mortgage-backed security is more relevant than the security’s maturity – rarely does a bond fulfill its term
weighted average life or simply average life is used to determine the inherent interest rate risk – the greater the maturity, the higher the interest rate risk Bullet bond: - prepay principal only once, at maturity date Weighted average life = Sum of “t x projected principal received at time t / (12 x total principal) |
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Factors that affect prepayments
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Prevailing mortgage rate – the spread and the path of mortgage rates since the loan was originated affects prepayments (aka refinancing burnout – those who could refinance, already have) – is the spread great enough to compensate for costs associated with refinance: legal expense, origination fees, title insurance, and the value of the time it takes to get a new mortgage loan (typically need 250-350bps spread)
Housing turnover – lower rates increase the affordability of homes and economic growth improves personal income and in opportunities for “worker migration,” resulting in turnover Characteristics of the underlying residential mortgage loans – the amount of seasoning (the older/more mature, the higher prepayment rate) and the geographical location of the underlying properties (some regions prepay faster than others – local economies, turnover rates, etc.) |
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Collateralized mortgage obligation (CMO)
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redirects cash flows of mortgage-related products to different bond classes, called tranches – to create different exposures to prepayment risk and therefore different risk/return patterns than the mortgage-related product from which they are created; broadening the appeal of mortgage-backed product to more investors
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Sequential pay tranche
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structured so that each class of bond would be retired sequentially – once one tranche’s principal is paid off completely, then go to the next tranche in the stack; interest is based on the principal remaining in each tranche – still a ton of variability in the average life for the tranches
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Accrual tranche
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when one tranche does not receive current interest, but instead the interest is accrued and added to the principal balance, while actually used to pay down the principal of earlier tranches; typically called the “Z bond” – shortens the maturity of all other tranches and lengthens its own maturity in the process
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Floating rate tranches
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collateral pays a fixed rate, but can create floating environment with the creation of a floater and inverse floating-rate tranche
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Structured Interest-Only Tranches
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where the tranche only receives interest (IO), done by setting the coupon rates for all the other tranches, below the collateral’s coupon rate so that excess interest can be generated and distributed to the IO
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Planned amortization tranche
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provides greater predictability of cash flow – because there is a principal repayment schedule that must be satisfied. PAC holders have priority over all other classes in the CMO structure in receiving principal payments from the collateral; PAC windows determine the length of time over which expected principal repayments are made – the narrower the window, the more it resembles a corporate bond with a bullet payment
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Support tranche
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protects the early PAC tranches from prepayment by absorbing a certain level of prepayments first (payments in excess of scheduled principal payments); “Busted” is the term used when support tranches are fully paid off
This investment would expose investors to the greatest amount of prepayment risk |
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Principal-only mortgage strips (POs)
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are purchased at a substantial discount from par, as returns are dependent on the speed of prepayment; the faster the prepayment, the higher the investor’s return
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Interest-only mortgage strips (IOs)
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have no par value or technical average life, and in contrast, IO investors want prepayments to be slow, as they will only receive interest on the principal outstanding
If rates fall below contract rates, prepayments would accelerate, and thus deteriorate the expected cash flow of the IO – often causing the price of the an IO to decline; if rates rise it could go either way, as the expected cash flow improves, but the cash flow is discounted at a higher interest rate its price tends to move in the same direction as the change in mortgage rates |
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Agency securities requirements
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are only underlying mortgages of 1 to 4 single family residential mortgages
Only conforming loans are included in pools, and three standards : the maximum loan to value (what % is the loan to the appraised value of the property), the maximum payment-to-income ratio, the maximum loan amount (jumbo if it exceeds a certain value over conforming) |
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Non-agency securities' characteristics
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can be for any type of real estate (could include home equity loans, manufactured housing loan-backed securities; quality of the servicer is often used to determine credit risk – can be passthroughs or CMOs (CMO not securitized as a passthrough, is called a whole loan)
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Main difference btw agency and non-agency
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the guarantee – non-agency has no explicit guarantee by the government, while agency does – to compensate for that credit risk, non-agency securities add external or internal enhancements
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Credit risk analysis of commercial and residential non-agency mortgage-backed securities
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CMBS are backed by a pool of commercial mortgage loans on income-producing property – initially used to either finance the purchase or to refinance a prior mortgage obligation
CMBS types – either multi-property single borrower, or multi-property conduit (commercial-lending entities established for the sole purpose of generating collateral to securitize) Commercial loans are nonrecourse – lender therefore can only look to the income-producing property backing the loan for interest and principal repayment; if there is a default, lender can only look to the sale of the asset for payback, but has rights to the cash flow in the meantime Credit analysis must be done on a loan by loan basis, at the time of issuance and then monitored |
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Basic CMBS structure
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the rating agency determines the necessary credit enhancements needed to achieve the desired rating level (often through subordination – their payouts are subordinate other bond classes in the structure); then required to pay the highest-rated bonds first; interest will be paid to all tranches and in the event of default the servicer will advance both principal and interest – until amounts are deemed “recoverable”; losses are charged to the lowest bond
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Call protection of CMBS (or prepayment protection)
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there are fees associated with prepayment – either at the loan level and/or the structure level
At the loan level: prepayment lockout, defeasance (paying the servicer and receiving replicable cash flows from treasury securities instead), prepayment penalty points, yield maintenance charges (makes it uneconomical to refinance solely to get a lower mortgage rate) At the structural level: CMBS’ are sequential pay, so based on investment grade ratings, the tranches will be paid off, while principal loss from defaults start from the bottom, up |
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Basic structure features of and parties to a securitization transaction
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Instead of issuing corporate bonds, a company can create a special purpose vehicle (SPV) to sell collateral into, where then the “issuer” or the “trust” of that SPV sells securities back by the collateral and pays the “seller”; and payments or income generated from the collateral are used to pay servicing and other administrative fees + principal and interest to the security holders
Parties involved include: the seller of the collateral (or the originator), the SPV (or the issuer/trust); and the servicer Other less relevant parties include the attorneys, independent accountants, trustees, underwriters, rating agencies, and guarantors |
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Prepayment tranching vs Credit tranching
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Prepayment tranching (or time tranching) – is done to redistribute prepayment risk; once one tranche is paid off, move on to the next
Credit tranching: to redistribute credit risk associated with the collateral – as long as there are no defaults by the borrower greater than the subordinate tranche values, the senior tranche will be paid in full |
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Payment structure of amortizing assets
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Payment Structure: amortizing assets are loans in which the borrower’s periodic payments consist of scheduled principal and interest payments over the life of the loan – based on an amortization schedule
a. Standard residential mortgage loans, auto loans, and certain home equity loans b. Partial prepayment (not the entire loan) is called curtailment |
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Payment structure of non-amortizing assets
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Non-amortizing assets require only minimum periodic payments with no scheduled principal repayment – and if the payment is less than the interest on the outstanding balance, the difference is applied to the outstanding loan balance (the concept of prepayment does not apply, since there is no schedule of principal payments – no amortization schedule
a. Credit card receivables |
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Collateral structure of a securitization backed by amortizing assets and
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the projection of the cash flows requires projecting prepayments, which may be impacted by the level of interest rates relative to the rate on the loan (refinancing), depends on the default rate and recovery rates after default
a. Amortization schedule is based on the gross weighted average coupon (GWAC) and the weighted average maturity (WAM) |
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Collateral structure of a securitization backed by non-amortizing assets
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projection of defaults is necessary (despite no prepayment “concept”) and how much could be recovered after default
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External credit enhancements
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a third party, monoline insurance company (or monoline insurer) or when securities are said to be wrapped (insurance, ensures timely payment coverage should the borrower fail to make the payment
letter of credit from a bank a guarantee by the seller of the assets #2 & 3 are considered weak link approach |
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Internal credit enhancements
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Reverse funds: cash reserve funds (straight deposits of cash generated from issuance proceeds), excess spread accounts (bps of excess payment beyond coupon + servicing fees that are reserved and can be used to pay for future losses
Overcollateralization: when the value of the collateral exceeds the amount of the par value of the outstanding securities issued by the SPV – will change due to defaults, amortization, and prepayments; used to absorb loss before the bond class structure Senior/Subordinated structures: where subordinate tranches “protect” senior tranches from prepayment |
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Home equity loans
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a loan backed by residential property (typically a second lien); typically now used when the borrower had an impaired credit history, or payment-to-income is too high to qualify as a conforming loan for securitization by the agencies
Can be either closed-end (fully amortized residential mortgage loan with fixed payments until maturity) or open-end (the homeowner is given a credit line dependent on the equity available within the property) CFs are comprised of interest, regularly scheduled principal repayments, and prepayments Prepayments – when CPR plateaus at 6% in month 30 – loan is considered to be seasoned – each issuer has different behaviors though, PPC (prospectus prepayment curve) is an issuer specific benchmark |
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Manufacturing housing loans
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manufacturing homes are built at a factory and then transported to a site – loan may be a mortgage (for land and the home) or a consumer retail installment loan; issued by Ginnie Mae and other private entities
If not backed by FHA or VA, called conventional loans (and are issued by private entities) Typically 15-20 years, fully amortizing the amount borrowed – so CFs are interest, principal (repayments and prepayments) Prepayments are more stable for this asset class (still measured by COR and each issue contains a PPC), because they are not sensitive to refinancing – as loans are typically small, and the rate of depreciation of mobile homes may cause early years depreciation to be greater than the amount of the loan paid off (tough to refinance this) |
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Automobile loans
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issued by financial subsidiaries of auto manufacturer; commercial banks, or independent finance companies and small financial institutions specializing in auto loans
Tiered by credit quality – “prime auto loans” are the top – typically of high quality, because they are a secured form of lending, they begin to repay principal immediately through amortization, and they are short-term in nature – also tend to have prudent underwriting standards CFs – regularly scheduled monthly loan payments (interest and scheduled principal repayments) and any prepayments – which may arise from 1) sales and trade-ins requiring full payoff of the loan; 2) repossession and subsequent resale of the automobile; 3) loss or destruction of the vehicle; 4) payoff of the loan with cash to save on the interest rate; 5) refinancing of the loan at a lower interest rate (minor here) – often done at below markets rate as part of sales promotions Prepayments – measured in terms of absolute prepayment speed (ABS) – which is based on the original collateral vs. SMM (monthly CPR) which is based on the prior month’s balance |
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Student loans
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made to cover college cost (all levels) and tuition for a wide range of vocational and trade schools – “SLABS” are most often made under the FFELP (facilitated via private lenders, but guaranteed up to 98% by the US gov’t)
Sallie Mae similar to Fannie and Freddie, but for student loans CFs are typically in three periods: deferment period (no payments made), grace period (typically 6 months when no payments are due post-graduation), and loan repayment period Typically floating-rate loans |
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Small Business Administration (SBA) loans
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small business administration agency of the US government empowered to issue loans to qualified borrowers (fully backed by the gov’t), mostly variable rate loans with the prime rate used as the reference rate (reset monthly/quarterly); there is a max coupon rate, and maturity is between 5-25 years
Monthly CF = the coupon interest based on the coupon rate set for that period, the scheduled principal repayment, prepayments (which are measured in terms of CPR) |
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Credit card receivables
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when the credit card lender extends credit to the cardholder/borrower
At the time of purchase, the cardholder is agreeing to repay the amount borrowed + any financial charges Credit card receivables are used as collateral for the issuance of the asset-backed security CFs = finance charges collected (on unpaid balances), fees, and principal Credit card receivable-backed security is a nonamortizing security; there is typically a lock out period where investors solely receive fees and finance charges, while any principal paid is reinvested; after the lock out period, principal is paid out to investors as well as fees Payment structure is either: a. Pass-through structure – principal is paid on a pro rata basis b. controlled-amortization structure: principal is established, and periodic payment is set low so that payments can be made even if defaults or slow payment occurs c. bullet-payment structure: entire amount in one distribution – maturity date is often not guaranteed, but often satisfied at some point |
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Collateralized debt obligations (CDOs)
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a security backed by a diversified pool of one of more of the following types of debt obligations: US domestic high-yield corporate bonds; structured financial products (mortgage-backed, asset-backed securities); emerging market bonds, bank loans, and special situation loans and distressed debt
Funds to purchase the underlying assets are obtained from the issuance of debt obligations – tranches: each tranche is its own place in the stack, and will seek to obtain ratings, except for the subordinate/equity tranche that receives the residual cash flow (no rating is sought) The ability to pay off the tranches/make interest and principal payments as they occur is dependent on the performance of the underlying assets – can come from coupon interest payments, maturing assets in the underlying pool, or the sale of assets in the underlying pool Derivatives (or swaps) are often used to match payments between floating rate and fixed rate tranches, otherwise would be “mis-matched” |
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Cash CDOs
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is backed by a pool of cash market debt instruments
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Synthetic CDO
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is a CDO where the investor has the economic exposure to a pool of debt instrument, but this exposure is realized via a credit derivative instrument rather than the purchase of cash market instruments
Credit default swaps: buying insurance against credit risk on a reference asset |
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Balance sheet CDOs
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motivation of the sponsor is to remove debt instruments (primarily loans) from its balance sheet (typically financial institutions looking to reduce their capital requirements by removing loans due to their higher risk-based capital requirements
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Arbitrage CDOs
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motivation of the sponsor is to earn the spread between the yield offered on the debt obligations in the underlying pool and the payments made to the various tranches in the structure
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Cash flow yield definition + its limitations
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the interest rate that makes the present value of the expected cash flow equal to its market price plus accrued interest
the main limitation is that the cash flows are unknown because of prepayments – so to determine cash flow yield, you need to make an assumption about the prepayment rate + default rate + recovery rate (in all but mortgage-backed securities) Other limitations include: to realize the stated yield, need to be able to: i. Reinvest the coupon payments at a rate equal to yield to maturity ii. Hold the bond to the maturity date |
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Bond equivalent yield:
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converts monthly yield into annual yield
2 *(((1 + Monthly Interest Rate)^6) – 1) |
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Nominal spread
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compare the yield to a comparable treasury yield (i.e. same maturity) to determine the nominal spread; a portion of this spread is the “acceptance of prepayment risk”
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Option adjusted spread (OAS)
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the compensation after adjusting for prepayment risk within the nominal spread
when dealing with structured products with options that are intended to be used, it is best to use OAS vs. the Z-spread |
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Zero volatility spread
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the spread investors will realize over the entire treasury spot rate curve (at each maturity) if the mortgage or asset-backed security is held to maturity
will make the PV of the CFs from the MB or AB security, when discounted at the treasury spot rate plus the spread equal to the price of the security the shorter the maturity, the less the z-spread will differ from the nominal spread the difference also depends on the shape of the yield curve, the steeper the yield curve, the greater the difference when dealing with structured products with options that are intended to be used, it is best to use OAS vs. the Z-spread |
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Monte Carlo simulation model for valuing a mortgage-backed security
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Interest rate path dependent – the cash flow received in one period is determined not only by the current interest rate level, but also by the path that interest rate took to get to the current level (prepayment burnout can occur when everyone who was able to refinance, already did)
Generating a set of cash flows based on simulated future mortgage refinancing rates, which in turn imply simulated prepayment rates Simulating interest rate paths and CFs requires a calibration such that the average simulated price of a zero-coupon treasury bond equals today’s actual price – the model builder must make an arbitrary adjustment to the interest rate paths to get the model to be arbitrage free |
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Path dependency
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the cash flow received in one period is determined not only by the current interest rate level, but also by the path that interest rate took to get to the current level (prepayment burnout can occur when everyone who was able to refinance, already did)
dependency is caused by the unknown variable of prepayment rates, and how the change in interest rates causes different prepayment reactions. Investors will either use the Monte Carlo simulation or specify a number of representative paths – where the weighted average representative paths are used to value the pass-through securities |
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How the option-adjusted spread is calculated using the Monte Carlo simulation model and how this spread measure is interpreted
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In the monte carlo model, the OAS is the spread that when added to all the spot rates on all interest rate paths will make the average PV of the paths equal to the observed market price (plus accrued interest) – essentially used to reconcile value with market price
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Evaluating a mortgage-backed security using option-adjusted spread analysis
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OAS represents compensation for credit and liquidity risk, but also modeling risk
Option cost = Zero-volatility spread – option-adjusted spread Tranches do not necessarily share OAS equally; Z-spread and option cost increase as the effective duration increases Higher OAS makes an investment more attractive, especially if option cost is limited (less risk) While the changes in OAS are about the same for the difference tranches, the changes in price are quite different – shorter tranches have less duration The longer the duration, the greater the risk – and when volatility declines, the reward is greater for the accepted risk The collateral will trade at a premium, if the homeowners are paying a higher rate than the given market rate – also means that the value of the collateral would increase if prepayments slow down, but would decrease if prepayments increase – BUT even if the collateral is trading at a premium, the tranche could be trading at a discount, par or premium – this is dependent on tranches’ coupon rate with regard to the current market rate YOU WANT HIGH OAS and LOW Option Cost – BEST VALUE Lower volatility increases the value of the collateral, while higher volatility reduces that value The longer the life – greater exposure to prepayment risk, but in terms of volatility, not much variance whether volatility is high or low |
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Duration vs. Effective Duration
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the measure of the price sensitivity to changes in interest rates
Effective duration is most appropriate for bonds with embedded options, and effective convexity as well, to capture negative convexity when need be |
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Why effective durations reported by various dealers and vendors may differ
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Differences in the amount of the rate shock used
Differences in prepayment models Differences in the option-adjusted spread Differences in the relationship between s-term interest rates and refinancing rates |
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Cash flow duration
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is a form of effective duration, as it assumes cash flows will change with a change in rates (modified duration assumes no change in cash flows, and thus a constant prepayment rate, 165 PSA verse a change from 150 to 200PSA depending on rate changes)
Limitations with regard to MBS: is superior to modified duration because it assumes prepayment, but is naïve in its assumption about how prepayments may change – Monte Carlo simulation is therefore superior |
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Coupon curve duration
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uses market prices to estimate the duration of a mortgage-based security, by rolling up and down the coupon curve and using market prices to compute duration
Limitations with regard to MBS: limited to generic MBS and difficult to use for mortgage derivatives such as CMOs |
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Empirical duration
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values used within the duration formula are based on some valuation model – historical market prices and market yields are used
Limitations with regard to MBS: a reliable price series may not be available, an empirical relationship does not impose a structure for the options embedded in a MBS and can therefore cause distortion, and the volatility of the spread to Treasury yields can distort how the price of a MBS reacts to yield changes |
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Z-Spread
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the spot rate + the zero volatility spread as the discount rate used for valuation – it does not account for a prepayment option; used for option-free bonds
When there is no embedded option or the prepayment option is not exercised – the z-spread is = to the OAS |
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When is OAS used?
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OAS is used when there is an embedded option and it is expected to be exercised – after OAS is selected, determine between a binomial model and the Monte Carlo simulation model
Monte Carlo OAS is required when the structure is interest rate path dependent, i.e. MBS Binomial OAS can be used when the structure is NOT interest rate path dependent: callable corporate or agency debenture, or putable bond |
