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CMTA Advanced Treasury Workshop Floating Rate Notes, Fixed to Float Securities, Step Down Bonds and Convexity Presented by: Tony Garcia, CFA Vice President Pomona, CA January 31, 2012
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1 If you can’t explain it to a six year old, you don’t understand it yourself. -Albert Einstein
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On the Agenda Floating Rate Securities A security where the coupon floats relative to an index Fixed to Float Securities A security that has a fixed coupon for a period and then converts to a floating rate security Step Down Bonds A callable security where the coupon declines Negative Convexity The bane of callable buyers 2
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Floating Rate Securities
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Coupon Floats Relative to Index (Benchmark or Reference rate) Coupon Rate = reference rate (index) +/- quoted margin Indexes Fed Funds – Daily Reset Libor – O/N, 1 Month, 3 Month, 6 Month, 12 Month CMT – Spread to Constant Maturity Treasury with regular resets Commercial Paper Prime Rate Treasury Bill – 1 Month, 3 Month, 6 Month TIPS – Inflation Indexed Inverse Floaters – Where the coupon moves in the opposite direction to the reference rate *You cannot buy these* 4
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Floating Rate Securities Issuers Treasury – TIPS Agencies – Debentures and Asset Backed Municipalities Corporations Discount Margin Effective spread to index Caps and Floor Cap – The limit to which a coupon can float Floor – Minimum possible coupon Collar – When security has both a cap and a floor 5
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Components Of Pricing Spread to Index determines coupon Reset Frequency Maturity Change in Basis 6
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Discount Margin Discount margin is the inferred change in spread to Index Price changes to reflect change in market Price change = PV of change in DM As with YTM 7
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Basis Risk Change in DM to reflect adjustments in market If credit quality improves DM should decline If credit quality deteriorates DM will widen If spreads narrow DM will decline May also change due to change absolute level of interest rates 8
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ING BANK Step Up FRN Source: Bloomberg 9
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ING BANK Step Up FRN Source: Bloomberg 10
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ING BANK Step Up FRN Source: Bloomberg 11
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Value To A Portfolio Lower Duration Reset frequency lowers effective duration Lower Price volatility Yield will move in direction of underlying index 12
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Berkshire FRN 2/11/13 Reset 3 MO Libor +43 Source: Bloomberg 13
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Berkshire FRN 2/11/13 Reset 3 MO Libor +43 Source: Bloomberg 14
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Berkshire FRN and Treasury 2.75% 2/13 BRK FRN 2/13 TSY 2.75 2/13 DATE PRICE YIELD PRICE YIELD 2/11/10 100.000 DM + 43 104.012 1.40 1/11/11 100.905 DM + 13 106.419 0.62 CHANGE +.905 DM -30 +2.407 -0.78 Note: Settlement date held static at 2/11/10 to avoid amortization effect 15
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Fixed to float securities
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Fixed to Floating Rate Securities 17 Securities begin with a Fixed Coupon rate for specified period then will switch to a Floating Rate Coupon May be bulleted or callable Issued by Agencies and Corporations Can provide protection against rising rates Basis shift out of a low volatility environment can be a concern
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Agency Fixed to Float 18 Source: Bloomberg
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Agency Fixed to Float – Coupons 19 Source: Bloomberg
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Corporate Fixed to Float 20 Source: Bloomberg
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Agency Fixed to Float – Coupons 21 Source: Bloomberg
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Step down bonds
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Step Down Callable Security structure where coupon steps down if bond not called Likelihood of call is very small Short term cash flow is the focus 23
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Source: Bloomberg Step Down Callable 24
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Step Down Callable – YTC Schedule Source: Bloomberg 25
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5 Year Treasury Yield Source: Bloomberg 26
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One Time Callable Source: Bloomberg 27
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Agency Bullet Yield Curve Source: Bloomberg 28
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Step Down Callable OAS Analysis Source: Bloomberg 29
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Callable Agency OAS Analysis Source: Bloomberg 30
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Step Down Callable – Comparison YTMOption value Step Down 2.080.59 Callable 2.401.82 Treasury 2.07 Agency Bullet 2.25 31
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Step Down Callable – Cash Flows 32
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Convexity
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Convexity/Negative Convexity Convexity A Measure of how curved the price-yield curve is The second derivative of the price-yield function Low coupon and long maturity bonds tend to have high convexities High coupon and short maturity bonds tend to have low convexities Negative Convexity Where the rate of change of the price of a bond slows as rates fall Generally due to embedded option(s) 34
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Price / Yield Function 35 PRICE YIELD
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Duration 36 PRICE YIELD
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Convexity 37 PRICE YIELD { }
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Convexity Changes 38 PRICE YIELD
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Negative Convexity 39 PRICE YIELD
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Negative Convexity 40 PRICE YIELD
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12 Month Horizon Return 41 Pricing Date: 01/16/2013 Type: Spot Curve Currency: USD Horizon Months: 12 Reinvestment Rate:.104 IssuerCouponMaturityYTWEff DurConvFieldName-300-200-1000100200300 BULLET0.75001/12/20180.8504.8860.133 Total Return14.2549.8305.5991.555-2.313-6.013-9.553 Ending Price112.950108.547104.337100.31196.46192.77889.253 Ending Avg Life4.000 Ending Eff Dur3.9893.9673.9463.9253.9053.8843.864 Ending Conv0.0900.0890.0880.087 0.0860.085 STEP UP0.70001/30/20180.7002.188-1.406 Total Return0.350 0.5250.547-1.465-4.880-8.463 Ending Price100.000 97.86194.44590.860 Ending Avg Life0.000 3.0003.5004.000 Ending Eff Dur0.000 2.4873.4013.870 Ending Conv0.000 -0.3070.2170.061 CALLABLE1.00001/11/20181.0002.504-1.647 Total Return0.486 0.540-1.753-5.442-8.975 Ending Price100.000 97.24593.55490.019 Ending Avg Life0.000 4.000 Ending Eff Dur0.000 3.3153.8613.842 Ending Conv0.000 -0.4800.0830.084 FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13 Coupons: 0.70 to 1/16 0.875 to 7/16 1.0 to 1/17 2.0 to 7/17 3.0 to 1/18 FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13 FHLMC 0.75% 1/12/18 Source: Bloomberg and Bond Edge
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12 Month Horizon Return 42 Pricing Date: 01/16/2013 Type: Spot Curve Currency: USD Horizon Months: 12 Reinvestment Rate:.104 IssuerCouponMaturityYTWEff DurConvFieldName-300-200-1000100200300 BULLET0.75001/12/20180.8504.8860.133 Total Return14.2549.8305.5991.555-2.313-6.013-9.553 Ending Price112.950108.547104.337100.31196.46192.77889.253 Ending Avg Life4.000 Ending Eff Dur3.9893.9673.9463.9253.9053.8843.864 Ending Conv0.0900.0890.0880.087 0.0860.085 STEP UP0.70001/30/20180.7002.188-1.406 Total Return0.350 0.5250.547-1.465-4.880-8.463 Ending Price100.000 97.86194.44590.860 Ending Avg Life0.000 3.0003.5004.000 Ending Eff Dur0.000 2.4873.4013.870 Ending Conv0.000 -0.3070.2170.061 CALLABLE1.00001/11/20181.0002.504-1.647 Total Return0.486 0.540-1.753-5.442-8.975 Ending Price100.000 97.24593.55490.019 Ending Avg Life0.000 4.000 Ending Eff Dur0.000 3.3153.8613.842 Ending Conv0.000 -0.4800.0830.084 FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13 Coupons: 0.70 to 1/16 0.875 to 7/16 1.0 to 1/17 2.0 to 7/17 3.0 to 1/18 FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13 FHLMC 0.75% 1/12/18 Source: Bloomberg and Bond Edge
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12 Month Horizon Return 43 Pricing Date: 01/16/2013 Type: Spot Curve Currency: USD Horizon Months: 12 Reinvestment Rate:.104 IssuerCouponMaturityYTWEff DurConvFieldName-300-200-1000100200300 BULLET0.75001/12/20180.8504.8860.133 Total Return14.2549.8305.599 1.555 -2.313-6.013-9.553 Ending Price112.950108.547104.337 100.311 96.46192.77889.253 Ending Avg Life4.000 Ending Eff Dur3.9893.9673.946 3.925 3.9053.8843.864 Ending Conv0.0900.0890.088 0.087 0.0860.085 STEP UP0.70001/30/20180.7002.188-1.406 Total Return0.350 0.525 0.547 -1.465-4.880-8.463 Ending Price100.000 97.86194.44590.860 Ending Avg Life0.000 3.0003.5004.000 Ending Eff Dur0.000 2.4873.4013.870 Ending Conv0.000 -0.3070.2170.061 CALLABLE1.00001/11/20181.0002.504-1.647 Total Return0.486 0.540 -1.753-5.442-8.975 Ending Price100.000 97.24593.55490.019 Ending Avg Life0.000 4.000 Ending Eff Dur0.000 3.3153.8613.842 Ending Conv0.000 -0.4800.0830.084 FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13 Coupons: 0.70 to 1/16 0.875 to 7/16 1.0 to 1/17 2.0 to 7/17 3.0 to 1/18 FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13 FHLMC 0.75% 1/12/18 Source: Bloomberg and Bond Edge
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Portfolio Comparison – Bullets vs Callables 44 Security detail Portfolio BulletsPortfolio Callables Par$70,000,000Par $70,000,000 Market Value$71,085,000Market Value$70,225,000 Average Life1.328Average Life1.246 YTM0.517YTM0.918 Modified Duration1.31Modified Duration3.32 Effective Duration1.16Effective Duration1.30 Convexity 0.10 Convexity -0.77 Porfolio distribution Source: Bloomberg and Bond Edge
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Security Shock Testing 45 Source: Bloomberg and Bond Edge
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Security Shock Testing 46 Source: Bloomberg and Bond Edge
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Security Shock Testing 47 Source: Bloomberg and Bond Edge
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Dynamic Cash Flow Shock Testing 48 Source: Bloomberg and Bond Edge
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- - Douglas Adams I love deadlines. I love the whooshing noise they make as they go by. 49
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Contact Information 50 Tony Garcia, CFA Vice President MAC A0716-07T 400 Capitol Mall, 7 th Floor Sacramento, CA 95814 Phone: (888) 267-9113 FAX: (916) 442-2750 Email: tgarcia@wellsfargo.comtgarcia@wellsfargo.com
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The opinions expressed in this presentation are general in nature and not intended to provide specific advice or recommendations. Contact your investment representative, attorney, accountant or tax advisor with regard to your specific situation. The opinions of the author do not necessarily reflect those of Wells Fargo Institutional Securities, LLC or any other Wells Fargo entity. Wells Fargo Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including Wells Fargo Securities, LLC, a member of NYSE, FINRA, NFA and SIPC, Wells Fargo Institutional Securities, LLC, a member of FINRA and SIPC, Wells Fargo Prime Services, LLC, a member of FINRA, NFA and SIPC and Wells Fargo Bank, National Association. Wells Fargo Securities, LLC carries and provides clearing services for Wells Fargo Institutional Securities, LLC customer accounts. Investments offered are not FDIC insured · May lose value · No bank guarantee © 2013 Wells Fargo Securities. All rights reserved. 51
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