1. © 2009 McGraw-Hill Ryerson Limited 19- 1 Chapter 19 Government Bonds and Mortgage-Backed Securities Prepared by Ayşe Yűce Ryerson University

2. © 2009 McGraw-Hill Ryerson Limited 19- 2 Chapter nineteen outline Government bond basics Government bond basics Treasury bills, notes, bonds and strips Treasury bills, notes, bonds and strips Bank of Canada auctions Bank of Canada auctions Canada Savings Bonds Canada Savings Bonds Provincial and municipal bonds Provincial and municipal bonds Mortgage-Backed Securities Mortgage-Backed Securities A brief history of Mortgage-Backed Securities A brief history of Mortgage-Backed Securities Fixed-rate mortgages Fixed-rate mortgages Canada Mortgage and Housing Corporation Canada Mortgage and Housing Corporation

3. © 2009 McGraw-Hill Ryerson Limited 19- 3 Government Bonds Our goal in this chapter is to examine the securities issued by federal, provincial, local governments and mortgage-backed securities. Our goal in this chapter is to examine the securities issued by federal, provincial, local governments and mortgage-backed securities.

4. © 2009 McGraw-Hill Ryerson Limited 19- 4 Government Bond Basics In 2003, the gross public debt of the Canadian government was approximately $120 billion. In 2003, the gross public debt of the Canadian government was approximately $120 billion. The Bank of Canada finances government debt by issuing marketable as well as non- marketable securities. The Bank of Canada finances government debt by issuing marketable as well as non- marketable securities. Provincial and municipal government debt is also a large debt market. Provincial and municipal government debt is also a large debt market.

5. © 2009 McGraw-Hill Ryerson Limited 19- 5 Government Bond Basics Marketable securities can be traded among investors. Marketable securities can be traded among investors. Marketable securities issued by the government include T-bills, and Canada Bonds. Marketable securities issued by the government include T-bills, and Canada Bonds. Non-marketable securities must be redeemed by the issuer. Non-marketable securities must be redeemed by the issuer. Non-marketable securities include Canada Savings Bonds. Non-marketable securities include Canada Savings Bonds.

6. © 2009 McGraw-Hill Ryerson Limited 19- 6 Treasury Bills (T-bills) T-bills are Short-term obligations with maturities of 13, 26, or 52 weeks (when issued). T-bills are Short-term obligations with maturities of 13, 26, or 52 weeks (when issued). T-bills pay only their face value (or redemption value) at maturity. T-bills pay only their face value (or redemption value) at maturity. Face value denominations for T-bills are as small as $1,000. Face value denominations for T-bills are as small as $1,000. T-bills are sold on a discount basis (the discount represents the imputed interest on the bill). T-bills are sold on a discount basis (the discount represents the imputed interest on the bill).

7. © 2009 McGraw-Hill Ryerson Limited 19- 7 Canada Bonds Canada bonds are long-term obligations with maturities of more than 10 years (when issued). Canada bonds are long-term obligations with maturities of more than 10 years (when issued). Canada bonds pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity). Canada bonds pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity). These bonds have face value denominations as small as $1,000. These bonds have face value denominations as small as $1,000.

8. © 2009 McGraw-Hill Ryerson Limited 19- 8 STRIPS STRIPS: Separate Trading of Registered Interest and Principal of Securities. STRIPS: Separate Trading of Registered Interest and Principal of Securities. STRIPS were originally derived from Canada bonds. STRIPS were originally derived from Canada bonds. A 30-year bond can be separated into 61 strips - 60 semiannual coupons + a single face value payment. A 30-year bond can be separated into 61 strips - 60 semiannual coupons + a single face value payment. STRIPS are effectively zero coupon bonds (zeroes). STRIPS are effectively zero coupon bonds (zeroes). The YTM of a STRIP is the interest rates the investors will receive if the STRIP is held until maturity. The YTM of a STRIP is the interest rates the investors will receive if the STRIP is held until maturity.

9. © 2009 McGraw-Hill Ryerson Limited 19- 9 Calculating the Price of a STRIPS What is the price of a STRIPS maturing in 20 years with a face value of $10,000 and a semiannual YTM of 7%? What is the price of a STRIPS maturing in 20 years with a face value of $10,000 and a semiannual YTM of 7%? The STRIPS price is calculated as the present value of a single cash flow. That is, The STRIPS price is calculated as the present value of a single cash flow. That is,

10. © 2009 McGraw-Hill Ryerson Limited 19- 10 Zero Coupon Bond Prices

11. © 2009 McGraw-Hill Ryerson Limited 19- 11 Zero Coupon Bond Prices

12. © 2009 McGraw-Hill Ryerson Limited 19- 12 Prices for Canadian Bonds Prices for Canadian Bonds Figure 19.2

13. © 2009 McGraw-Hill Ryerson Limited 19- 13 Straight Bond Prices and Yield to Maturity Recall: The price of a bond is found by adding together the present value of the bond’s coupon payments and the present value of the bond’s face value. The formula is: Recall: The price of a bond is found by adding together the present value of the bond’s coupon payments and the present value of the bond’s face value. The formula is: In the formula, C represents the annual coupon payments (in $), FV is the face value of the bond (in $), and M is the maturity of the bond, measured in years. In the formula, C represents the annual coupon payments (in $), FV is the face value of the bond (in $), and M is the maturity of the bond, measured in years.

14. © 2009 McGraw-Hill Ryerson Limited 19- 14 Bond Prices and YTM

15. © 2009 McGraw-Hill Ryerson Limited 19- 15 Real Return Canadian Bonds In recent years, the Bank of Canada has issued securities that guarantee a fixed rate of return in excess of realized inflation rates. In recent years, the Bank of Canada has issued securities that guarantee a fixed rate of return in excess of realized inflation rates. These inflation-indexed Canadian bonds : These inflation-indexed Canadian bonds : Pay a fixed coupon rate on their current principal, and Pay a fixed coupon rate on their current principal, and Adjust their principal semiannually according to the most recent inflation rate Adjust their principal semiannually according to the most recent inflation rate

16. © 2009 McGraw-Hill Ryerson Limited 19- 16 Bank of Canada Auctions The Bank of Canada conducts regularly scheduled auctions for government securities. The Bank of Canada conducts regularly scheduled auctions for government securities. The Bank posts auction, results, and other details at: www.bankofcandada.ca The Bank posts auction, results, and other details at: www.bankofcandada.ca www.bankofcandada.ca

17. © 2009 McGraw-Hill Ryerson Limited 19- 17 Bank of Canada Auctions, Details At each Treasury auction, the Federal Reserve accepts sealed bids of two types. At each Treasury auction, the Federal Reserve accepts sealed bids of two types.  Competitive bids specify a bid price/yield and a bid quantity. Such bids can only be submitted by Treasury securities dealers.  Noncompetitive bids specify only a bid quantity, and may be submitted by individual investors. The price and yield of the issue is determined by the results of the competitive auction process. The price and yield of the issue is determined by the results of the competitive auction process.

18. © 2009 McGraw-Hill Ryerson Limited 19- 18 Auctions, More Details All noncompetitive bids are accepted automatically and are subtracted from the total issue amount. All noncompetitive bids are accepted automatically and are subtracted from the total issue amount. Then, a cut-off yield is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount. Then, a cut-off yield is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount. All bids at or above the cut-off yields are accepted. All bids at or above the cut-off yields are accepted.

19. © 2009 McGraw-Hill Ryerson Limited 19- 19 Canada Savings Bonds The Bank of Canada offers an investment opportunity for individual investors by issuing two types of Savings Bonds: regular interest and compound interest bonds. These bonds The Bank of Canada offers an investment opportunity for individual investors by issuing two types of Savings Bonds: regular interest and compound interest bonds. These bonds Have face value denominations ranging from $100 to $10,000,. Have face value denominations ranging from $100 to $10,000,. Accrue interest semiannually and Accrue interest semiannually and Can be redeemed for the original price plus all prior accrued interest at any Canadian financial institution. Can be redeemed for the original price plus all prior accrued interest at any Canadian financial institution. They are non-callable and non-transferable. They are non-callable and non-transferable.

20. © 2009 McGraw-Hill Ryerson Limited 19- 20 Canada Premium Bonds Very similar to Canada Savings Bond. Very similar to Canada Savings Bond. However they provide higher returns. However they provide higher returns. Accrue interest semiannually (the interest rate is set at a fixed rate plus the recent inflation rate), and Accrue interest semiannually (the interest rate is set at a fixed rate plus the recent inflation rate), and Can be redeemed for the original price plus all prior accrued interest once a year. Can be redeemed for the original price plus all prior accrued interest once a year. To get more information, visit www.csb.gc.ca. To get more information, visit www.csb.gc.ca.

21. © 2009 McGraw-Hill Ryerson Limited 19- 21 Provincial and Municipal Bonds Provincial and municipal bonds, are intermediate- to long-term interest-bearing obligations of provincial and local governments, or agencies of those governments. Provincial and municipal bonds, are intermediate- to long-term interest-bearing obligations of provincial and local governments, or agencies of those governments. They are RRSP eligible and provide tax deduction in retirement plans. They are RRSP eligible and provide tax deduction in retirement plans.

22. © 2009 McGraw-Hill Ryerson Limited 19- 22 Municipal Bonds Table 19.2

23. © 2009 McGraw-Hill Ryerson Limited 19- 23 Types of Municipal Bonds Bonds issued by a municipality that are secured by the full faith (are known as general obligation bonds (GOs). Bonds issued by a municipality that are secured by the full faith (are known as general obligation bonds (GOs). Municipal bonds secured by revenues collected from a specific project or projects are called revenue bonds. Example: Airport and seaport development bonds that are secured by user fees and lease revenues. Municipal bonds secured by revenues collected from a specific project or projects are called revenue bonds. Example: Airport and seaport development bonds that are secured by user fees and lease revenues.

24. © 2009 McGraw-Hill Ryerson Limited 19- 24 Provincial and Municipal Bond Credit Ratings Table 19.3

25. © 2009 McGraw-Hill Ryerson Limited 19- 25 Mortgage-Backed Securities Next we will examine the investment characteristics of mortgage pools. Next we will examine the investment characteristics of mortgage pools. Mortgage pools are simply sets of home mortgages, which are "bonds" issued by home owners. Mortgage pools are simply sets of home mortgages, which are "bonds" issued by home owners.

26. © 2009 McGraw-Hill Ryerson Limited 19- 26 A Brief History of Mortgage-Backed Securities Traditionally, local banks wrote most home mortgages and then held the mortgages in their portfolios of interest-earning assets. Traditionally, local banks wrote most home mortgages and then held the mortgages in their portfolios of interest-earning assets. Then, when market interest rates climbed to near 20% in the early 1980s, bank customers flocked to withdraw funds from their savings deposits to invest in money market funds. Then, when market interest rates climbed to near 20% in the early 1980s, bank customers flocked to withdraw funds from their savings deposits to invest in money market funds. Today, a mortgage originator usually sells the mortgage to a mortgage repackager, who accumulates them into mortgage pools. Today, a mortgage originator usually sells the mortgage to a mortgage repackager, who accumulates them into mortgage pools.

27. © 2009 McGraw-Hill Ryerson Limited 19- 27 A Brief History of Mortgage-Backed Securities Financed by mortgage-backed bonds (also called mortgage pass-throughs), each mortgage pool is set up as a trust fund. Financed by mortgage-backed bonds (also called mortgage pass-throughs), each mortgage pool is set up as a trust fund. A servicing agent collects the mortgage payments from the home-owners and then passes the cash flows through to the bondholders. A servicing agent collects the mortgage payments from the home-owners and then passes the cash flows through to the bondholders. The transformation from mortgages to mortgage-backed securities (MBSs) is called mortgage securitization. The transformation from mortgages to mortgage-backed securities (MBSs) is called mortgage securitization.

28. © 2009 McGraw-Hill Ryerson Limited 19- 28 Fixed-Rate Mortgages A Fixed-Rate Mortgage is a loan that specifies constant monthly payments at a fixed interest rate over the life of the mortgage. A Fixed-Rate Mortgage is a loan that specifies constant monthly payments at a fixed interest rate over the life of the mortgage. The size of the monthly payment is determined by the requirement that the present value of all monthly payments, based on the financing rate specified in the mortgage contract, be equal to the original loan amount. The size of the monthly payment is determined by the requirement that the present value of all monthly payments, based on the financing rate specified in the mortgage contract, be equal to the original loan amount.

29. © 2009 McGraw-Hill Ryerson Limited 19- 29 Fixed-Rate Mortgage, Monthly Payments The equation to calculate the payment required to “retire” a fixed rate mortgage is: The equation to calculate the payment required to “retire” a fixed rate mortgage is: In the equation, ris the annual mortgage financing rate, and T is the number of years in the mortgage term. In the equation, ris the annual mortgage financing rate, and T is the number of years in the mortgage term.

30. © 2009 McGraw-Hill Ryerson Limited 19- 30 Monthly Payments In Canada mortgage payments are compounded semi-annually and therefore we have to use effective annual rate instead of annual fixed rate. Effective annual rate for semi-annual compounding is calculated as follows: In Canada mortgage payments are compounded semi-annually and therefore we have to use effective annual rate instead of annual fixed rate. Effective annual rate for semi-annual compounding is calculated as follows:

31. © 2009 McGraw-Hill Ryerson Limited 19- 31 Monthly Payments We then substitute this rate instead of r in our previous equation to find monthly payments. For example a Canada mortgage holder with 8% annual mortgage rate will pay the following monthly amount. We then substitute this rate instead of r in our previous equation to find monthly payments. For example a Canada mortgage holder with 8% annual mortgage rate will pay the following monthly amount.

32. © 2009 McGraw-Hill Ryerson Limited 19- 32 Fixed-Rate Mortgage Amortization Each monthly mortgage payment has two separate components: Each monthly mortgage payment has two separate components: Payment of interest on outstanding mortgage principal Payment of interest on outstanding mortgage principal Pay-down, or amortization, of mortgage principal Pay-down, or amortization, of mortgage principal The relative amounts of each component change throughout the life of the mortgage. The relative amounts of each component change throughout the life of the mortgage.

33. © 2009 McGraw-Hill Ryerson Limited 19- 33 Fixed-Rate Mortgage Amortization Suppose a 30-year $100,000 mortgage loan is financed at a fixed interest rate of 8%. Suppose a 30-year $100,000 mortgage loan is financed at a fixed interest rate of 8%. In the first month: In the first month: Interest payment = $100,000 .08/12 = $666.67 Principal payment = $733.76 – $666.67 = $67.09 New principal = $100,000 – $67.09 = $99,932.91 In the second month: In the second month: Interest payment = $99,932.91 .08/12 = $666.22 Principal payment = $733.76 – $666.22 = $67.54 New principal = $99,932.91 – $67.54 = $99,865.37

34. © 2009 McGraw-Hill Ryerson Limited 19- 34 Fixed-Rate Mortgage Amortization Mortgage amortization can be described by an amortization schedule. Mortgage amortization can be described by an amortization schedule. An amortization schedule states the scheduled principal payment, interest payment, and remaining principal owed in any month. An amortization schedule states the scheduled principal payment, interest payment, and remaining principal owed in any month.

35. © 2009 McGraw-Hill Ryerson Limited 19- 35 Mortgage Amortization Schedule Table 19.5

36. © 2009 McGraw-Hill Ryerson Limited 19- 36 Fixed Rate Amortization Using Spreadsheet

37. © 2009 McGraw-Hill Ryerson Limited 19- 37 Mortgage Interest and Principal

38. © 2009 McGraw-Hill Ryerson Limited 19- 38 Fixed-Rate Mortgage Prepayment and Refinancing A mortgage borrower has the right to pay off all or part of the mortgage ahead of its amortization schedule. This is similar to the call feature of corporate bonds and is known as mortgage prepayment. A mortgage borrower has the right to pay off all or part of the mortgage ahead of its amortization schedule. This is similar to the call feature of corporate bonds and is known as mortgage prepayment. During periods of falling interest rates, mortgage refinancings are an important reason for mortgage prepayments. During periods of falling interest rates, mortgage refinancings are an important reason for mortgage prepayments. This means that mortgage investors face the risk of a reduced rate of return. This means that mortgage investors face the risk of a reduced rate of return.

39. © 2009 McGraw-Hill Ryerson Limited 19- 39 Canada Mortgage and Housing Corporation The Canada Mortgage and Housing Corporation (CHMC),” is a government agency charged with the mission of promoting liquidity in the secondary market for home mortgages. The Canada Mortgage and Housing Corporation (CHMC),” is a government agency charged with the mission of promoting liquidity in the secondary market for home mortgages. Mortgages in CHMC pools are said to be fully modified because CHMC guarantees bondholders full and timely payment of both principal and interest. Mortgages in CHMC pools are said to be fully modified because CHMC guarantees bondholders full and timely payment of both principal and interest.

40. © 2009 McGraw-Hill Ryerson Limited 19- 40 Canada Mortgage and Housing Corporation Although investors in CMHC pass-throughs do not face default risk, they still face prepayment risk. Although investors in CMHC pass-throughs do not face default risk, they still face prepayment risk. Prepayments are passed through to bondholders. Prepayments are passed through to bondholders. If a default occurs, CMHC fully “prepays” the bondholders. If a default occurs, CMHC fully “prepays” the bondholders.

41. © 2009 McGraw-Hill Ryerson Limited 19- 41 MBS Yields

42. © 2009 McGraw-Hill Ryerson Limited 19- 42 MBS Yields

43. © 2009 McGraw-Hill Ryerson Limited 19- 43 Useful Websites www.investinginbonds.com (lots of information on bonds, bonds, bonds) www.investinginbonds.com (lots of information on bonds, bonds, bonds) www.investinginbonds.com www.bankofcanada.ca ( visit the Bank of Canada) www.bankofcanada.ca ( visit the Bank of Canada) www.bankofcanada.ca www.ustreas.gov (visit the U.S. Treasury) www.ustreas.gov (visit the U.S. Treasury) www.ustreas.gov www.fin.gc.ca (learn about Canadian Bonds) www.fin.gc.ca (learn about Canadian Bonds) www.fin.gc.ca www.publicdebt.treas.gov (lots of information on Treasury securities) www.publicdebt.treas.gov (lots of information on Treasury securities) www.publicdebt.treas.gov

44. © 2009 McGraw-Hill Ryerson Limited 19- 44 Useful Websites www.savingsbonds.com (for the latest on Savings Bonds) www.savingsbonds.com (for the latest on Savings Bonds) www.savingsbonds.com www.municipalbonds.com (check out munis) www.municipalbonds.com (check out munis) www.municipalbonds.com www.cmhc.ca (visit the CMHC website) www.cmhc.ca (visit the CMHC website) www.cmhc.ca

45. © 2009 McGraw-Hill Ryerson Limited 19- 45 Chapter Review Government Bond Basics Government Bond Basics Treasury Bills, Bonds, and STRIPS Treasury Bills, Bonds, and STRIPS Canadian Government Bonds Canadian Government Bonds Real Return Canadian Bonds Real Return Canadian Bonds Bank of Canada Auctions Bank of Canada Auctions Canada Savings Bonds Canada Savings Bonds

46. © 2009 McGraw-Hill Ryerson Limited 19- 46 Chapter Review Provincial and Municipal Bonds Provincial and Municipal Bonds Municipal and Provincial Bond Credit Ratings Municipal and Provincial Bond Credit Ratings Mortgage-Backed Securities Mortgage-Backed Securities A Brief History of Mortgage-Backed Securities A Brief History of Mortgage-Backed Securities Fixed-Rate Mortgages Fixed-Rate Mortgages Fixed-Rate Mortgage Amortization Fixed-Rate Mortgage Amortization Fixed-Rate Mortgage Prepayment and Refinancing Fixed-Rate Mortgage Prepayment and Refinancing Canada Mortgage and Housing Corporation Canada Mortgage and Housing Corporation