Fixed Income Zvi Wiener Fixed Income 3

FI - 3 slide 2 Government-Sponsored Enterprises Fannie Mae “benchmark” and Freddie Mac “reference” notes and bond. Can be electronically transferred through clearing houses as Euroclear and Cedel and NBES. Outstanding amount $150B with 2-30 years to maturity.

FI - 3 slide 3 Government-Sponsored Enterprises GNMA - Government National Mortgage Association FHLBS - Federal Home Loan Bank System Sallie Mar - Student Loan Marketing Association

FI - 3 slide 4 Corporate Debt Instruments corporate bonds medium-term notes CP = commercial papers ABS = asset backed securities They have priority over common stocks in the case of bankruptcy.

FI - 3 slide 5 Corporate Bonds Main types of issuers utilities transportation industrial banks and financial companies

FI - 3 slide 6 Bond Indentures trustee term bonds, serial bonds collateral debenture bond - not secured guaranteed bonds

FI - 3 slide 7 Bond Provisions Call and refund provisions - the issuer has the right to redeem the entire amount before maturity. Sometimes there is a premium to be paid in such a case (redemption schedule). Special redemption prices for debt redeemed through the sinking fund Refunding means replacing by another debt.

FI - 3 slide 8 Bond Provisions Sinking fund provision sometimes the issuer is required to retire a portion of an issue each year. – either by cash payment to bondholders (lottery) – or by buyback bonds

FI - 3 slide 9 Bond Rating Duff and Phelps Credit Rating Co. Fitch Investors Service Moody’s Investors Service Standard & Poor’s Corporation

FI - 3 slide 10 Rating Moody’sS&PFitchD&P AaaAAAAAAAAA Aa1AA+AA+AA+ Aa2AAAAAA Aa3AA-AA-AA- A1A+A+A+ A2AAA A3A-A-A-

FI - 3 slide 11 Rating BBB- or better = investment grade BB+ and below - speculative grade D to DDD default transition matrix

FI - 3 slide 12 One year transition matrix AaaAaABaaBaBC&D Aaa Aa A Baa

FI - 3 slide 13 High Yield Bonds LBO, downgrading, refinancing fallen angels deferred interest bonds Step-up bonds pay initially low interest which increases with time

FI - 3 slide 14 SEC rule 144A Allows to trade private placements among qualified institutions.

FI - 3 slide 15 Medium Term Notes (MTN) Notes are registered with the SEC under Rule 415 (the shelf registration) and are offered continuously to investors by an agent of the issuer. Maturities vary from 9 months to 30 years. Can be either fixed or floating. Very flexible way to raise debt!

FI - 3 slide 16 Primary Market (MTN) Issuer posts spreads over Treasuries for a variety of maturities. Then an agent tries to find an investor. Minimal size is between $1M and $25M. The schedule can be changes at any time! Often structured MTNs are used (caps, floors, etc.) = structured notes.

FI - 3 slide 17 Structured Notes Many institutional investors can use swaps and structured notes to participate in markets that were prohibited. Another use of structured notes is in risk management. Financial Engineering is used to create securities satisfying the needs of investors.

FI - 3 slide 18 Commercial Papers Short term unsecured promissory note An alternative to short term bank borrowing A typical round-lot transaction is $100,000 In the USA maturity is up to 270 days Requires less paperwork Those with maturity up to 90 days can be used as collateral for FED discount window.

FI - 3 slide 19 Commercial Papers Typically rolled over Rollover risk is backed by an unused bank credit line In order to issue CP one need either a high rating or good collateral Sometimes credit enhancement is used (LOC) CP issued in the USA by foreigners are called Yankee CP

FI - 3 slide 20 Commercial Papers Between 71 an 89 there was one default on CP. 3 defaults occurred in 89 and 4 in 90 Direct paper is sold without an agent Secondary market is thin There is a special rating for CP, P-1,3, A-1,3 discount instruments, used by money market

FI - 3 slide 21 Bankruptcy and Credit Rights liquidation - all assets will be distributed reorganization - a new corporate entity will result a company that files for protection becomes a debtor in possession and continues to operate under the supervision of the court

FI - 3 slide 22 Bankruptcy and Credit Rights Absolute priority rule - senior creditors are paid in full before junior creditors are paid anything. Works in liquidation but often does not work in reorganization.

FI - 3 slide 23 Municipal Securities Exemption of interest income from federal taxation. Issued by states, counties, special districts, cities, towns, school districts.

FI - 3 slide 24 Municipal Securities Exemption of interest income from federal taxation. General obligation bonds - backed by tax power Limited tax general obligation bonds Revenue bonds - based on specific projects

FI - 3 slide 25 Municipal Securities Airport Revenue Bonds College and University Revenue Bonds Hospital Revenue Bonds Industrial Revenue Bonds Single-Family Revenue Bonds (mortgages) Multifamily Revenue Bonds (housing projects) Water Revenue Bonds

FI - 3 slide 26 Hybrid and Special Bond Securities Insured bonds - typically by an insurance firm Bank-backed municipal bonds (letter of credit) Refunded Bonds - a portfolio of safe securities is placed in trust and they will cover the payments. Troubled city bailout bonds

FI - 3 slide 27 Municipal Money Market Products TAN = tax anticipation notes RAN = revenue anticipation notes GAN = grant anticipation notes BAN = bond anticipation notes Tax exempt commercial paper

FI - 3 slide 28 Municipal Derivatives floaters = floating rate + spread inverse floaters = interest - floating rate strips partial strip = are zeros till a call date and then become coupon type

FI - 3 slide 29 Yield on Municipal Bonds tax-exempt yield equivalent taxable yield = 1-marginal tax rate for example bond offers 6.5% and marginal tax rate 40%: =

FI - 3 slide 30 Non-US Bonds national bond markets – domestic market – Foreign market  Yankee USA  Samurai Japan  bulldog UK  Rembrandt Holland  matador Spain

FI - 3 slide 31 International bond market Eurobond and Euroyen markets Global bond - simultaneous offering Typically registered in Luxembourg, London or Zurich, but traded OTC. Supranationals - IBRD, World Bank, etc.

FI - 3 slide 32 Eurobond market Dual currency bonds (coupon in one currency, principal in another). Option currency bond one side can choose the currency. Convertible bonds with warrants - can be converted into another asset. Equity, debt, gold or currency warrant.

FI - 3 slide 33 Eurobond market Floating Rate Notes = FRN based on LIBOR or LIBID many are collared some are perpetual

FI - 3 slide 34 Comparing Yields bond equivalent yield of Eurodollar bond =2[(1+yield to maturity) ] for example: A Eurodollar bond with 10% yield has the bond equivalent yield of 2[ ] = 9.762%

FI - 3 slide 35 Japanese Government Bonds JGB short term Treasury bills medium term bonds long term bonds super long term bonds (20 years)

FI - 3 slide 36 German Government Bonds U-Schatze discount paper up to 2 years Kassens = federal government notes (2-6 y.) OBLEs = 5 year federal government notes Bunds = federal government bonds (6-30 y.) all coupon payments are annual

FI - 3 slide 37 UK Government Bonds Gilts straights = bullet bonds (some callable) convertibles (option to holder to convert to longer gilts) index linked low coupon 2-2.5% irredeemable (perpetual)

FI - 3 slide 38 Brady Bonds Argentina, Brazil, Costa Rica, Dominican Republic, Ecuador, Mexico, Uruguay, Venezuela, Bulgaria, Jordan, Nigeria, Philippines, Poland. Partially collateralized by US government securities

FI - 3 slide 39 Internet sites

FI - 3 slide 40 Fixed Income 3 Mortgage loans Pass-through securities Prepayments Agencies MBS CMO ABS

FI - 3 slide 41 Mortgage Loans Mortgage is a loan secured by a specified real estate property. Conventional mortgage - credit of the borrower and collateral. Mortgage insurance - FHA, VA, FmHA guaranteed by US government, there are some private insurers as well.

FI - 3 slide 42 Mortgage Market Mortgage originator - thrifts, banks origination fee (in points = %) PTI = payment to income ratio (include tax) LTV = loan to value ratio later on mortgages are securitized.

FI - 3 slide 43 Mortgage Services Collecting payments, maintaining records Servicing fee - % of outstanding plus some other benefits. Mortgage insurer required when LTV>80%. Credit life - voluntary life insurance.

FI - 3 slide 44 Fixed Rate Mortgage A series of equal payments with PV=loan. Example: 100,000 for 20 years with 6% and equal monthly payments.

FI - 3 slide 45 Adjustable-Rate Mortgage (ARM) The contract rate is reset periodically, based on a short term interest rate. Adjustment from one month to several years. Spread is fixed some time caps or floors. Market based rates. Rates based on cost of funds for thrifts. Initially low rate is often offered = teaser rate.

FI - 3 slide 46 Balloon Mortgage One payment at the end. Sometimes they have renegotiation points.

FI - 3 slide 47 Two-Step Mortgages A loan carries a fixed rate for some period (usually 7 years) and then reset rates. For example: 250 basis points plus average of 10-years Treasuries.

FI - 3 slide 48 Risk in Mortgages Default risk Liquidity risk Interest rate risk Prepayment risk

FI - 3 slide 49 Risk in Mortgages Default risk is highly affected by LTV. LTV>80% in 40% of loans LTV>90% in 15% of loans different state laws give different rights to lenders.

FI - 3 slide 50 Prepayment Risk in Mortgages Sale of home Better interest rates Irrational factors

FI - 3 slide 51 Mortgage Pass-Through Securities A group of mortgages form a pool which is securitized. Payments are pooled, service fee deducted and the rest divided. WAC = weighted average coupon rate WAM = weighted average maturity

FI - 3 slide 52 Mortgage Pass-Through Securities Ginnie Mae = Government National Mortgage Association, MBS or GNMA. Freddie Mac = Federal Home Loan Mortgage Corporation, PC = participation certificate. Fannie Mae = Federal National Mortgage Association, MBS.

FI - 3 slide 53 Role of Agencies guarantee timely payments 1. Coupon only 2. Both coupon and principal Ginnie Mae is guaranteed by the US government. Securities guaranteed by Ginnie Mae are called MBS = Mortgage Backed Securitiy.

FI - 3 slide 54 Non-Agency Pass-Through Credit enhancement to AA or AAA. Overcollateralization Senior/subordinated structure shifting interest structure months% of prepayment to senior

FI - 3 slide 55 Prepayments Prepayment speed, conditional prepayment rate CPR. Single-Monthly mortality rate SMM. SMM = 1 - (1-CPR) 1/12 A general model should be based on a dynamic transition matrix, very similar to credit migration.

FI - 3 slide 56 Prepayments Prevailing mortgage rate relative to original. Path of mortgage rates. Level of mortgage rates. Seasonal factors (home buying is high in spring summer and low in fall, winter). General economic activity.

FI - 3 slide 57 Bond Equivalent Yield Bond equivalent yield = 2[ (1+y M ) 6 - 1] Yield is based on prepayment assumptions and must be checked! PSA benchmark = Public Securities Association. Assumes low prepayment rates for new mortgages, and higher rates for seasoned loans.

FI - 3 slide 58 Special Properties Negative convexity - if interest rates go up the price of a pass through security will decline more than a government bond due to lower prepayment rate.

FI - 3 slide 59 CMO and stripped MBS (ch. 12) Collateralized Mortgage Obligations - are bond classes created by redirecting the cash flows of mortgage related products so as to mitigate prepayment risk. CMO is backed by a pool of pass-throughs, whole loans, or strips, structured in order to serve different types of clients. The bond classes are called tranches.

FI - 3 slide 60 CMO Example Since sequential-pay CMO. Each class is retired sequentially. Example: collateral is a pass-through with par of $400M pass-through coupon rate 7.5% WAC weighted average coupon 8.125% WAM weighted average maturity 357 mo.

FI - 3 slide 61 CMO Example 4 tranches A,B,C,D divide the whole nominal, coupons will be distributed proportionally, but principals first go to A, until repaid, then to B, etc. Another example is an accrual CMO when one of the tranches does not get receive current interest. It is accrued and added to the principal.

FI - 3 slide 62 CMO Example Some tranches are floaters, others inverse floaters. Floater: Variable Rate + spread Inverse Floater: Spread - Variable Rate Often LIBOR is used as variable rate.

FI - 3 slide 63 Other CMOs PAC = Planned Amortization Class, IO = interest only, PO = principal only, IO, PO strips.

FI - 3 slide 64 ABS Asset-Backed Securities (13) Collateral, credit enhancement, Payment structure (priorities), legal structure (SPV=special purpose vehicle) Auto loan backed securities Credit Card backed securities Home Equity loans (second lien)