FIXED-INCOME: BASIC

CONCEPTS
CFA Level 1 – Study session 14
Christine Verpeaux, CFA
Contents
 Reading 42: Fixed-Income Securities: Defining
Elements
 Reading 43: Fixed-Income Markets: Issuance,
Trading, and Funding
 Reading 44: Introduction to Fixed-Income Valuation
 Reading 45: Introduction to Asset-Backed Securities
Fixed-Securities: Defining Elements
Reading 42
LOS
a. Describe the basic features of a fixed-income security
b. Describe content of a bond indenture
c. Compare affirmative and negative covenants and identify
examples of each
d. Describe how legal, regulatory, and tax considerations
affect the issuance and trading of fixed-income securities
e. Describe how cash flows of fixed-income securities are
structured
f. Describe contingency provisions affecting the timing and/or
nature of cash flows of fixed-income securities and identify
whether such provisions benefit the borrower or the lender.
Introduction
 Three important points about fixed-income securities:
 The most common type of fixed-income security is a bond
that promises to make a series of interest payments in fixed
amounts and to repay principal at maturity

 When market interest rates (bonds’ yields) the value of

fixed-rate bonds decrease because the present value of
the cash flows decreases

 Bonds are rated based on their relative probability of

default. Other things equal, a decrease in a bond’s rating
(an increased probability of default) will decrease the
price of the bond, thus increasing its yield
Basic features of a fixed-income
security
 Issuer of the bond
 Maturity of the bond
 Par value (principal value to be repaid)
 Coupon rate and frequency
 Currency in which payments will be made
Indenture and covenants
 Indenture: details the obligations of the issuer and the rights
of the bondholders.

 The bond indenture identifies the trustee as the representative

of the interests of the bondholders.

 Affirmative covenants: obligations of the borrower.

 Example: to submit periodic reports

 Negative covenants: restrictions to the borrower’s activities.

 Example: limitations on the borrower’s ability to incur additional
debt
Coupon characteristics
 Fixed
 Zero
 Step-up
 Deferred
 Floating
Fixed, Zero, Step-up and deferred
 Fixed: a bond with an 8% coupon rate and par value of $1,000
will pay annual interest of $80.

 Zero-coupon bond: interest is paid at the maturity date.

 Step-up notes: securities with a coupon rate that increases over time.

 Deferred coupon bonds: interest payments are deferred for a

specified number of years. The interest payments made after the
deferred period are higher to compensate the bondholder for the
lack of interest payments during the deferred period.
Floaters
 Floating rate note (FRN) or floater: coupon payments are
periodically reset.

 Examples:
 Coupon rate = 1-month LIBOR + 100 basis points
 Coupon rate = 5-yearTreasury yield – 90 basis points
 Interest is determined in advance and paid in arrear

 A floater may have a restriction on the maximum coupon

rate that will be paid and the maximum coupon rate is
called a cap.
Inverse Floaters
 Bonds which coupons move in opposite direction from the changes in
the reference rate.

 Interest of inverse floaters: investors who believe interest rates will

decline can enjoy the opportunity to purchase an inverse floater.

 Coupon rate = K – L x (reference rate).

 Example: coupon rate = 20% -2 x (3-month Treasury bill rate).

 A cap and a floor are imposed on the coupon rate.

TIPS (Treasury Inflation Protected
Securities)
 The reference rate of the coupon is the rate of inflation as
measured by the consumer price index.

 Example: in October 2001, the French Treasury Department

(Agence France Trésor) issued a 10-year bond that pays the
Eurozone CPI (Eurozone harmonized index of Consumer prices
ex-tobacco) plus 300 basis points.

 The characteristics of the OATei 3% 2012 are as follows:

 Par value: €1
 Redemption price = par x indexation coefficient (IC)
 IC = daily inflation reference at maturity date / base index
 Coupon: 3% x redemption price
Provisions for redemption and
retirement of bonds
 Bullet
 Amortizing
 Call provision
 Sinking fund provision
 Convertible
 Exchangeable
Bullet and amortizing
 Bullet: the entire amount is repaid in one lump sum at
the maturity date.

 Amortizing: principal payments over the life of the

bond in accordance with some specified schedule.
Sinking fund provision
 Under a sinking fund provision (“fond
d’amortissement”) bonds are either called using a
lottery (“remboursement par tirage au sort”) or
purchased on the open market (“rachat de titres sur
le marché secondaire”).
Call provision, put provision
 A call provision is a right granted to the borrower to redeem the issue early.
 The price which the issuer must pay to redeem the issue is the «call price» or
«redemption price».
 A bond may be either non callable or non refundable:
 A non callable bond may not be redeemed early except under certain
mandatory provisions
 A non refundable bond may not be redeemed with the proceeds of other debt
issues (holders are protected only if interest rates decline and the issuer can
borrow at lower cost)
 A put provision is a right (granted to holders) to sell the issue back to the issuer at a
specified price on designated date.
 The specified price is the put price.
 The advantage to the bond holder is that if market rates rise above the coupon
rate, the bondholder can force the issuer to redeem the bond at the put price and
reinvest the proceeds at market rates.
Convertible and exchangeable bonds

 A convertible bond grants the bondholder the right to

convert the bond for a specified number of shares of
common stock.

 An exchangeable bond allows the bondholder to

exchange the issue for a specified number of shares
of common stock of a corporation different from the
issuer of the bond.
Other issues addressed in a trust deed
 Issuing entities:
 Special purpose entities (SPEs), Special purpose Vehicles
(SPVs), or Special purpose companies (SPCs) are entities
created solely for the purpose of owning specific assets
and to provide funds to repurchase the assets
 Bonds issued by such entities are called securitized bonds
 Example: a firm could sell loans it has made to customers to
an SPV; the interest and principal on the loans are used to
make the interest and principal payments on the bond
 Often, an SPV can issue bonds at a lower rate than the
originating corporation because the assets supporting the
bonds are owned by the SPV and the SPV is a bankruptcy
remote vehicle
Other issues addressed in a trust deed

 Sources of repayment:
 Sovereign bonds: bonds typically repaid by the tax
receipts of the country
 Non-sovereign bonds: bonds repaid by either general
taxes, revenues of a specific project (e.g., an airport),
or by special taxes of fees dedicated to bond
repayment (e.g., water district)
 Corporate bonds: generally repaid from cash
generated by the firm’s operations
 Securitized bonds: repaid from the cash flows of the
financial assets owned by the SPV
Other issues addressed in a trust deed
 Collateral and credit enhancements
 Unsecured bonds: claim to the overall assets and cash flows of
the issuer
 Secured bonds: backed by a claim to specific assets of a
corporation (the asset pledged is referred to as collateral)
 Secured bonds are senior to unsecured bonds
 The claim of senior unsecured debt is below that of secured debt
but ahead of subordinated debt
 Debentures: in the U.S., refer to unsecured debt but in the U.K.
and some other countries, refer to bonds collateralized by
specific assets
 Covered bonds: bonds issued by financial companies in Europe
and some other regions, and offering the protection of a pool of
assets segregated into an SPV
Other issues addressed in a trust deed

 Credit enhancement can be either internal or

external:
 Internal credit enhancement:
 Overcollateralization: the collateral pledged has a value greater
than the par value of the debt issued
 Excess spread: the yield on the assets supporting the debt is
greater than the yield promised on the bonds issued
 Tranches: the bond issued is divided into tranches with different
seniority of claims
 A waterfall structure is a structure of cash flows in which the
available funds first go to the most senior tranche of bonds, then
to the next-highest priority bonds, and so forth…
Other issues addressed in a trust deed

 Credit enhancement can be either internal or

external (continued…):
 External credit enhancement:
 Surety bonds: promise to make up any shortfall in the cash
available to service the debt; issued by insurance companies
 Bank guarantees: same function; issued by a bank
 Letter of credit: promise to lend money to the issuing entity if it
does not have enough cash to make the promised payments
Legal, regulatory, and tax
considerations
 Bonds are subject to different legal and regulatory
requirements depending on where there are issued and
traded.
 Domestic bonds: bonds issued by a firm domiciled in a country
and traded in that country’s currency
 Foreign bonds: bonds issued by a firm incorporated in a foreign
country that trade on the national bond market of another
country that trade on the bond market and in the currency of this
country (Panda bonds, Yankee bonds, Matador bonds, Alpine
bonds…)
 Eurobonds: bonds issued outside the jurisdiction of any one
country and denominated in a currency different from the
currency in which they are sold; they are subject to less
regulation than domestic bonds in most jurisdictions and were
initially introduced to avoid U.S. regulation
Taxation of bond income
 Eurobonds: the majority of Eurobonds are issued in bearer form (more
attractive than registered bonds to those seeking to avoid taxes).
 Municipal bonds issued in the United States: most often exempt from national
income tax and often from any state income tax in the state of issue.
 Capital gains: often taxed at a lower rate than ordinary income.
 Long-term capital gains: taxed at an even lower rate (than short term capital
gains).
 Original issue discount (OID) bonds: issued at significant discount to par; can
generate a tax liability even when no cash payments are made (a portion of
the discount from par is treated as taxable interest income each year).
 Bonds issued at a premium: some tax jurisdiction allow part of the premium to
be used to reduce the taxable portion of coupons.
Fixed-Income Securities: Issuance,
Trading and Funding
Reading 43

2/3/2021
LOS
a. Describe classifications of global fixed-income markets
b. Describe the use of interbank offered rates as reference rates in
floating-rate debt
c. Describe mechanisms available for issuing bonds in primary markets
d. Describe secondary markets for bonds
e. Describe securities issued by sovereign governments
f. Describe securities issued by non-sovereign governments, quasi-
government entities, and supranational agencies
g. Describe types of bonds issued by corporations
h. Describe structured financial instruments (next reading)
i. Describe short-term funding alternatives available to banks
j. Describe repurchase agreements (repos) and the risks associated with
them
Fixed-income markets classification
 Type of issuer: government, government related, corporate, structured finance
(securitized bonds).
 Credit quality: investment grade (down to BBB) vs non-investment grade.
 Original maturity: money market securities (one year or less) vs capital market
securities.
 Coupon structure: floating-rate vs fixed rate.
 Currency denomination: most bonds are denominated in either U.S. dollar or
euros.
 Geography: domestic, foreign, Eurobonds; developed markets vs emerging
markets.
 Indexing: index-linked; inflation-linked bonds are issued primarily by
governments but also by corporations with high credit quality.
 Tax status: municipal bonds or munis (tax exempt in the U.S.).
Libor
 Libor (London Interbank Offered rate) is the most widely used
reference rate for floating-rate bonds.

 Libor rates are published daily for several currencies and for
maturities of one day (overnight rate) to one year.

 The rates are based on expected rates for unsecured loans from
one bank to another in the interbank money market. An average is
calculated from a survey of 18 banks’ expected borrowing rates in
the interbank market, after excluding the highest and lowest quotes.

 Libor has become the primary benchmark interest rate for many
short term US dollar loans to corporations although other reference
rates, such as Euribor, are also used.
Public offer / private offer
 Public offer: primary market transaction in which
anyone can apply to buy the bonds.

 Private offer: primary market transaction where

some customers are offered the stock.
Primary market transactions
 U.S. Treasury securities are sold through single price
auctions with the majority of purchases made by
primary dealers.

 Individuals can purchase U.S. Treasury securities

through the periodic auctions but they are small part
of the total.
Primary market transactions
 Bonds can be sold through an underwritten offering or a best
effort offering.

 Underwritten offering:
 The entire issue is purchased by the investment bank, termed the
underwriter
 Large issues are underwritten by a syndicate of investment banks
and the lead underwriter heads a syndicate of investment banks
who collectively establish the pricing and are responsible for
selling the bonds to dealers, who in turn, sell them to investors
 The syndicate takes the risk the bonds will not all be sold;
 Some bonds are traded on a when issued basis in what is called
the grey market
Primary market transactions
 Bonds can be sold through an underwritten offering or a best effort offering
(continued…).
 Best effort offering:
 The banks sell the bonds on a commission basis
 Unlike an underwritten offering, the banks do not commit to purchase the
whole issue
 Shelf registration:
 The bond issue is registered with securities regulators in its aggregate value
with a master prospectus
 Bonds can then be issued over time when the issuer needs to raise funds
 Shelf registration requires less disclosure than a separate registration of a
bond issue (only for sound companies)
 In some countries, bonds issued under a shelf registration can only be sold to
qualified investors
Secondary market transactions
 Take place mostly in the dealer, or over-the-counter market.

 Dealer market:
 Dealers post bid (purchase) prices and ask or offer (selling)
prices for various bond issues
 The difference between the bid and ask prices varies across
individual bonds according to their liquidity
 Trades are cleared through a clearing system
 Settlement typically takes place on the third trading day after
the trade date (T + 3) for corporate bonds, on the next trading
day after the trade date (T + 1) for government bonds, and on
the trade day (cash settlement) for some money market securities
Agency bonds
 Semi-government bonds are securities issued by
agencies established by a central government.

 In the U.S., semi-government bonds are referred to

as federal agency securities.

 They are further classified by the types of issuer:

 Issued by federally related institutions
 Issued by GSE (government-sponsored enterprises)
Overview of U.S. Federal Agencies
Securities
Federal Agency Securities

Government Sponsored
Federally related Institutions
Enterprises

Examples of Government
Examples of Federally related
Sponsored Enterprises
Institutions include
include

Tenessee
Freddy
Valley Ginnie Mae Fanny Mae Sally Mae
Mac
Authority

Collateralized
Mortgage Asset Backed
Mortgage
Passthrough Securities Securities
Obligations (CMOs)
U.S. Agency Mortgage Backed
Securities
 Mortgage Backed Securities are securities backed by
pools of mortgage loans.

 Agencies use the mortgage loans they underwrite or

purchase as collateral for the securities they issue.

 These securities include mortgage passtrough securities,

collateralized mortgage obligations (CMOs) and
stripped mortgage-backed securities.

 Most countries have similar mortgage products.

Mortgage-backed securities
 A mortgage loan is a loan that is collateralized with a
specific piece of real property, either residential or
commercial.

 Therefore the loan is based on the credit worthiness of

the borrower and is collateralized by the real estate that
it is used to purchase.

 The mortgage lender may require mortgage insurance to

secure the loan. Mortgage insurance is available by both
government agencies and private insurers.
Supranational bonds
 Issued by supranational agencies, also known as
multilateral agencies: World Bank, IMF, Asian
Development Bank.

 Typically have high credit quality and very liquid.

Debt issued by corporations
 Bank debt:
 Bilateral loans: typically Libor-based, variable-rate loans
 Syndicated loans: funded by several banks
 There is a secondary market in syndicated loans interest…

 Commercial paper:
 Short-term unsecured debt securities issued by large creditworthy
corporations
 Used to fund working capital and as a temporary source of funds prior
to issuing long-term debt (bridge financing)
 Issued with maturities of 270 days or less in the U.S. to avoid SEC
registration
 ECP (Eurocommercial paper) issued with maturities as long as 364 days
Debt issued by corporations
 Commercial paper (continued…):
 In order to get an acceptable credit rating from the rating
agencies on their commercial paper, corporations maintain
backup lines of credit with banks, referred to as liquidity
enhancement or backup liquidity lines.
 The bank agrees to provide the funds when the paper
matures, if needed, except in the case of material adverse
change (if the company’s financial situation has
deteriorated significantly).
 In the U.S., commercial paper is typically issued as a pure
discount security while ECP rates are quoted as an add-on
yield.
Corporate bonds
 Corporate bonds:
 Short term (maturity of up to 5 years), medium term
(maturity from 5 to 12 years), long term ( maturity
exceeding 12 years)
 Issued with various coupon structures and with both fixed-
rate and floating-rate coupons
 May be secured or unsecured
 May have call, put, or conversion features
 Serial bond issue: bonds issued with several maturity dates
so that a portion is redeemed periodically; compared to a
bond with a sinking fund provision, investors know at
issuance when specific bonds will be redeemed
 Term maturity structure: all bonds mature on the same date
Corporate bonds
 Medium-term notes (MTNs):
 Not necessarily medium-term in maturity;
 Issued in various maturities, ranging from 9 months to periods as
long as 100 years;
 Issuers provide maturity ranges for MTNs they wish to sell and
yield quotes for those ranges;
 Investors interested in purchasing the notes make an offer to the
issuer’s agent and the agent makes the transaction;
 Can have fixed or floating-rate coupons, but longer-maturity
MTN’s are typically fixed-rate;
 Can be combined with derivative instruments to create a
structured security;
 Typically issued by financial corporations and purchased by
financial institutions.
Short-term funding available to banks
 Customer deposits: pay no interest.
 Savings accounts: pay periodic interest.
 Certificates of deposit:
 Non-negotiable: cannot be sold; withdrawal of funds often
incurs a penalty.
 Negotiable: traded in both domestic markets and in the
Eurobond market.
 Central bank funds: banks with excess reserves lend them
to other banks for periods of one day or for longer periods
up to a year; central bank funds rates refer to rates for
these transactions; in the U.S., this is the Fed funds rate.
 Interbank funds: funds other than central bank funds that
are loaned by one bank to another.
The repo market
 Agreement by which one party sells a security to a
counterparty with a commitment to buy it back at a later
date at higher price.

 A reverse repo agreement refers to taking the opposite

side of a repurchase transaction (lending fund by buying
the collateral).

 Overnight repo: for one day.

 Term repo: for a longer period.

The repo market
 Example:
A firm enters into a repo agreement to sell a 4%, 12-
year bond with a par value of $1 million, and a
market value of $970,000, for $940,000 and to
repurchase it 90 days later for $947,050
 The implicit interest rate for the 90-day period is
947,050 / 940,000 – 1 = 0.75%
 The repo rate is the equivalent annual rate
 The difference between the market value of
$970,000 and the amount of the loan ($940,000) is
the repo margin or hair cut
Introduction to Fixed-Income
Valuation
Reading 44

2/3/2021
LOS
a. Calculate a bond’s price given a market discount rate
b. Identify the relationship among a bond’s price, coupon rate,
maturity and market discount rate (yield-to-maturity)
c. Define spot rates and calculate the price of a bond using
spot rates
d. Describe and calculate the flat price, accrued interest, and
the full price of a bond
e. Describe matrix pricing
f. Calculate and interpret yield measures for fixed-rate
bonds, floating-rate notes, and money-market instruments
g. Define and compare the spot curve, yield curve on coupon
bonds, par curve, and forward curve
LOS
h. Define forward rates and calculate spot rates from
forward rates, forward rates from spot rates, and
the price of a bond using forward rates
i. Compare, calculate, and interpret yield spread
measures
Bond’s price given a market discount
rate
 The value of a single cash flow to be received in the
future is the amount of money that must be invested
today to generate the future value.

 The resulting value is called the present value (also

called the discounted value) of a cash flow.

 The present value will depend on i) the timing of the

cash flow and ii) the discount rate used.
Bond’s price given a market discount
rate
 The value of a coupon paying bond is the sum of the
present value of all expected cash flows.

 The market discount rate is called the bond’s yield-

to-maturity (YTM):

 𝑃𝑉 𝑜𝑓 𝑏𝑜𝑛𝑑’𝑠 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 =

𝑛 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑖𝑛 𝑡𝑖
𝑖=1 (1+𝑌𝑇𝑀)𝑡𝑖
Example
 Consider a simple bond that matures in four years,
has a coupon of 10%, and a maturity value of 100

 Assume annual interest payments and a discount rate

of 8%
Example
Discount rate 8%

Year Cash Flow Discount Factor Present Value

1 10 0.925926 9.26
2 10 0.857339 8.57
3 10 0.793832 7.94
4 110 0.735030 80.85
106.62
Present Value properties
 For a given discount rate, the further into the future
a cash flow is received, the lower its present value.

 The higher the discount rate, the lower the present

value.

 The shape of the present value curve is convex.

Relationship between coupon rate, market discount rate, and price relative to par
value

 Coupon rate = yield required by market, price =

par value.

 Coupon rate > yield required by market, price >

par value.

 Coupon rate < yield required by market, price <

par value.
Change in bond’s value as it moves
towards maturity
 Assuming no change in the discount rate, the bond’s
value :
1. Decreases over time if the bond is selling at a
premium
2. Increases over time if the bond is selling at a
discount
3. Is unchanged if the bond is selling at par value

 This phenomenon is referred to as “pull-to-par

value”.
Price of a bond using spot rates
 The spot interest rate is the discount rate for one single
payment. It is equivalent to the yield of a zero-coupon bond.

 The theoretical spot rates represent the appropriate set of

interest rates that should be used to value default-free cash
flows.

 Suppose that the appropriate discount rates are as follows :

 year 1: 6.8% ; year 2: 7.2% ; year 3: 7.6% ; year 4: 8.0%.
 For the 4-year 10% coupon bond, the present value of each
cash flow is:
 Price of a bond using spot rates

Year Cash Flow Spot rate Discount factor Present Value

0 1.0000
1 10 6.80% 0.9363 9.3633
2 10 7.20% 0.8702 8.7018
3 10 7.60% 0.8027 8.0272
4 110 8.00% 0.7350 80.8533
106.9456
Valuing semi-annual cash flows
 The convention in the bond market is to quote annual
interest rates that are just double semiannual rates.

 Consider once again the 4-year coupon bond with a

maturity value of 100.

 Assuming the coupon payments are semiannual,

given the cash flows and the semi-annual discount
rate of 4%, the present value of the bond is:
Valuing semi-annual cash flows
Discount rate 8%
Coupon rate 10%
Frequency 2

Period Cash Flow Discount Factor Present Value

1 5 0.961538 4.81
2 5 0.924556 4.62
3 5 0.888996 4.44
4 5 0.854804 4.27
5 5 0.821927 4.11
6 5 0.790315 3.95
7 5 0.759918 3.80
8 105 0.730690 76.72
106.7327
Accrued interest, full price and flat
price
 The coupon is paid to the bondholder in record.

 Thus, if an investor sells a bond between coupon

payments and the buyer holds it until the next coupon
payment, the entire coupon will be earned by the buyer.

 The seller of the bond gives up the interest from the time
of the last coupon to the date of the trade.

 The amount of interest over this period is called accrued

interest.
Accrued interest, full price and flat
price
 In the U.S. and in many countries, the bond buyer must
pay the bond seller the agreed upon price plus accrued
interest.
 This amount is called the full price or dirty price.
 The agreed upon price without accrued interest is
referred to as the flat price or clean price.
 There are exceptions to the rule that the bond buyer
must pay the seller the accrued interest.
 The most important exception is when the issuer has not
fulfilled its promise to pay the interest.
 In such a case, the bond is sold without accrued interest
and is said to be traded flat.
Matrix pricing
 Matrix pricing is a method of estimating the
required yield-to-maturity of bonds that are
currently not traded or infrequently traded.

 The procedure is to use the YTM of traded bonds

that have credit quality close to that of the bond
and are similar in maturity and coupon, to estimate
the required YTM.
Example
 A bond analyst is estimating the value of a non traded 4%,
annual-pay, BB rated bond that has five years remaining until
maturity.

 He has obtained the following yields-to-maturity on similar

corporate bonds:
 BB rated, 4-year annual pay, 5% coupon bond: YTM = 4.738%
 BB rated, 6-year annual pay, 4% coupon bond: YTM = 5.232%
 BB rated, 6-year annual pay, 6% coupon bond: YTM = 5.284%

 Estimate the value of the non traded bond.

Example
Answer:
 Step 1: take the average YTM of the 6-year bonds: (5.232% +
5.284%) = 5.258%

 Step 2: take the average of the 4-year bond with the average 6-
year bond yield: (4.738% + 5.258%) / 2 = 4.998%

 Compute the bond price with a YTM of 4.998%

 With the TI BAII+, the parameters are:

 N = 5; PMT = 40; FV = 1,000; I/Y = 4.998
 CPT -> PV = -956.79
Matrix pricing
 Consider a case where we are estimating the value of a
5-year, 5% annual-pay coupon bond and have the YTMs
of otherwise similar bonds with 4-year and 7-year
maturities: 4.738% and 5.336% respectively.

 The calculation is:

 YTM = 4.738% + (5 – 4) / (7 – 4) x (5.336% - 4.738%)
= 4.937%

 With the TI BAII+, the parameters are:

 N = 5; PMT = 50; FV = 1,000; I/Y = 4.937
 CPT -> PV = -1,002.73
Example
 A bond analyst is estimating the spread for a new 6-
year, A rated bond issue.

 He has obtained the following market yields:

 5-year, U.S. Treasury bond, YTM = 1.48%
 5-year, A rated corporate bond, YTM = 2.64%
 7-year, U.S. Treasury bond, YTM = 2.15%
 7-year, A rated corporate bond, YTM = 3.55%
 6-year, U.S. Treasury bond, YTM = 1.74%

 Estimate the required yield on the new 6-year, A rated

corporate bond.
Example
Answer:
 Step 1: calculate the spread on the 5-year corporate bond: 2.64%
- 1.48%) = 1.16%

 Step 2: calculate the spread on the 7-year corporate bond: 3.55%

- 2.15%) = 1.40%

 Step 3: calculate the average spread because the 6-year bond is

the midpoint of 5 and 7 years: average spread = (1.16% +
1.40%) / 2 = 1.28%

 Step 4: add the average spread to the YTM of the 6-year Treasury
bond: 1.74% + 1.28% = 3.02%
Yield measures for fixed-rate bonds, floating-rate notes, and money market
instruments

 The effective (annual) yield for a bond depends on how many

coupon payments are made each year.

 An annual pay-bond with an 8% YTM has an effective yield of 8%.

 A semiannual–pay bond with an 8% YTM has an effective yield of

1.04² - 1 = 8.16%.

 Example:
 A bond is quoted with a YTM of 4% on a semi-annual pay basis
 What yield should be used to compare it with a quarterly-pay bond?
Yield measures for fixed-rate bonds, floating-rate notes, and money market
instruments

 Answer:
 Yieldto compare this with the yield of a quarterly-
pay bond = (1.021/2 – 1) x 4 = 3.98%
Yield measures for fixed-rate bonds, floating-rate notes, and money market
instruments

 Bond yields: calculated using street convention

(bonds yields calculated using the stated coupon
payment dates).

 True yields: calculated using the actual coupon dates

when some coupon dates fall on weekends and
holidays.
Current yield
 The simplest measure of the yield on a bond is the current
yield, also known as the flat yield, interest yield or running
yield.

 The running yield is given by:

 Current yield = annual cash coupon payment / bond price

 Example:
 Consider a 20-year, $1,000 par value, 6% semiannual-pay
bond that is currently trading at a flat price of $802.07
 Calculate the current yield
Current yield vs simple yield
Answer:
 Current yield = 60 / 802.07 = 0.0748 = 7.48%

 The current yield is based on annual coupon interest so

that it is the same for a semiannual-pay and annual-pay
bond with the same coupon rate and price.

 Simple yield: takes the discount or premium into account

by assuming that any discount or premium declines
evenly over the remaining years to maturity.
Yield-to-call and yield to worst
 Consider a 10-year, semiannual-pay 6% bond
trading at 102 on January 1, 2014.

 The bond is callable according to the following

schedule:
 Callable at 102 on or after January 1, 2019
 Callable at 100 on or after January 1, 2022

 Calculate the bond’s YTM, yield-to-first call, yield-

to-first par call, and yield-to-worst.
Yield-to-call and yield to worst
Answer:
 The yield to maturity on the bond is calculated as:
 P/Y = 2; N = 20; PMT = 30; FV = 1,000; PV = -1,020
 CPT -> I/Y = 5.73%

 The yield-to-first-call is calculated as:

 P/Y = 2; N = 10; PMT = 30; FV = 1,020; PV = -1,020
 CPT -> I/Y = 5.88%

 The yield-to-first par call is calculated as:

 P/Y = 2; N = 16; PMT = 30; FV = 1,000; PV = -1,020
 CPT -> I/Y = 5.69%
Option adjusted yield
 The option-adjusted yield is calculated by adding the
value of the call option to the bond’s current flat
price.

 The option-adjusted yield will be less than the yield-

to-maturity for a callable bond.

 The option-adjusted yield can be used to compare

the yields of bonds with various embedded options
to each other and to similar option-free bonds.
Floating-rate notes
 Quoted margin: margin used to calculate the bond coupon payment.

 Required margin or discount margin: the margin required to return

the FRN to its par value.

 A simplified way of calculating the value of an FRN on a reset date

is to use the current reference rate plus the quoted margin to
estimate the future cash flows for the FRN and to discount these
future cash flows at the reference rate plus the discount margin.

 There are more complex models that produce better estimates of

value.
Example
 A semiannual $1,000 par value FRN has two years
to maturity, the reference rate is 180-day Libor, and
the quoted margin is 60 basis points.

 180-day Libor today (a coupon payment and reset

date) is 3% and the discount margin is 86 basis
points.

 Calculate the value of the FRN.

Example
Answer:
 Coupon rate = (180-day Libor + quoted margin) / 2 =
(3.00% + 0.60%) / 2 =1.80%

 Coupon payments = 1.80% x $1,000 = $18

 The appropriate discount rate is 180-day Libor + discount

margin = 3.00% + 0.86% = 3.86%

 The estimated value of the FRN today is calculated as:

 P/Y = 2; N = 4; PMT = 18; I/Y = 3.86; FV = 1,000
 CPT -> PV = -995.04
Yields for money market instruments
Example: money market yields
1. A $1 million 90-day T-bill is priced with an annualized
discount rate of 1.2%; calculate its annualized add-on yield
based on a 365-day year.

2. A $1 million negotiable CD with 120 days to maturity is

quoted with an add-on yield of 1.4% based on a 365-day
year; calculate the payment at maturity for the CD and its
bond equivalent yield.

3. A bank deposit for 100 days is quoted with an add-on yield

of 1.5% based on a 360-day year; calculate the bond
equivalent yield on a semi-annual bond basis.
Yields for money market instruments
Answer
1. PV = $1 million (1 – 1.2% x 90 / 360) = $997,000; Annualized add-on
based on a 365-day year = (future value / present value – 1) x 365 / 90 =
($1 million / $997,000 – 1) x 365 / 90 = 1.22%

2. Payment at maturity = future value = $1 million (1 + 1.4% x 120 / 365) =

$1,004,602.74; the BEY is the same as the quoted rate. *This answer
suggests that the BEY is in fact the notion of BEY in Canada (in Canada, the
BEY is a flat yield computed on a 365 days basis).
3. Holding period yield = 1.5% x 100 / 360 = 0.4167%; EAY = (1 +
HPY)365/100 - 1= 1.5292%; BEY on a semi-annual bond basis = ((1 +
1.5292%)1/2 – 1) x 2 = 1.5234%
Spot curve, yield curve, par curve, and
forward curve
 Yield curve for coupon bonds: shows the YTMs for coupon bonds at
various maturities.

 Spot rate yield curve or strip curve: the spot interest rate is the
discount rate for one single payment. It is equivalent to the yield of
a zero-coupon bond. The theoretical spot rates represent the
appropriate set of interest rates that should be used to value
default-free cash flows.

 Par curve: not calculated from yields on actual bonds but

constructed from the spot curve. The yields reflect the coupon rate
that a hypothetical bond at each maturity would need to have to
be priced at par. Alternatively, par yields can be viewed as the
YTM of a par bond at each maturity.
Relationship between short-term forward rates and spot rates

 A forward rate is a borrowing/lending rate for a loan to be made at some

future date. The notation used must identify both the length of the
lending/borrowing period and when in the future the money will be
loaned/borrowed.

 For example, 1y1y is the rate for a 1y loan to be made one years from now.

 Consider a 2 year investment period divided into 2 periods.

 The relationship between the 2-year spot rate S2, S1, and 1y1y is :
(1 + 𝑆2)2 = (1 + 𝑆1) (1 + 1𝑦1𝑦)
Relationship between short-term forward rates and spot rates

 By extension, the relationship between Sn, S1 and the successive forward rates is
written:
 (1 + 𝑆𝑛 ) 𝑛 = 𝑛−1
𝑖=0 (1 + 𝑖𝑦1𝑦)

 Otherwise said:
𝑛 𝑛−1
 𝑆𝑛 = 𝑖=0 1 + 𝑖𝑦1𝑦 − 1

 And the ny1y is calculated as follows:

(1+𝑆𝑛+1 )𝑛+1
 𝑛𝑦1𝑦 = (1+𝑆𝑛 )𝑛
−1

 Finally, the nymy is calculated as follows:

1+𝑆𝑛+𝑚 𝑛+𝑚 1 𝑛
 m𝑦𝑛𝑦 = ( 1+𝑆𝑚 𝑚
) −1
Example
 The current 1-year spot rate is 2%, the 1-year forward rate one year from
today is 3%, and the 1-year forward rate two years from today is 4%.

 Calculate the 3-year spot rate.

 (1 + 𝑆3 ) 3 = 2
𝑖=0(1 + 𝑖𝑦1𝑦)
3 2 3
 𝑆3 = 𝑖=0 1 + 𝑖𝑦1𝑦 − 1 = 1 + 2% 1 + 3% 1 + 4% − 1 =
2.997%

 This can be interpreted to mean that a dollar compounded at 2.997% for

three years would produce the same ending value as a dollar that earns
compound interest of 2% the first year, 3% the next year, and 4% for the
third year.
Example
 The 2-period spot rate, S2, is 8%, and the 1-period
spot rate S1, is 4%.

 Calculate the forward rate for one period, one

period from now.
(1+𝑆𝑛+1 )𝑛+1 1+8% 1+1
 1𝑦1𝑦 = −1= − 1 = 12.154%
(1+𝑆𝑛 )𝑛 1+4% 1
Example
 The current 1-year spot rate is 4%, the current 2-year spot
rate is 8%, and the current 3-year spot rate is 12%.

 Calculate the 1-year forward rates, one year from now and
two years from now, and the 2-year forward rate, one year
from now.
(1+𝑆𝑛+1 )1+1 1+8% 2
 1𝑦1𝑦 = −1= − 1 = 12.154%
(1+𝑆𝑛 )1 1+4% 1
(1+𝑆3 )2+1 1+12% 3
 2𝑦1𝑦 = −1= − 1 = 20.45%
(1+𝑆2 )2 1+8% 2
1
1+𝑆2+1 1+2 1 1+12% 3 2
 2𝑦1𝑦 = ( 1 ) 2 −1 = − 1 = 16.228%
1+𝑆1 1+4% 1
Computing a bond value using forward
rates: example
 The 1-year spot rate is 4%, the 1-year forward rate
one year from now is 5%, and the one-year forward
two years from now is 6%.

 Calculate the value of a 3-year annual-pay bond,

with a 5% coupon, and a par value of $1,000.
Computing a bond value using forward
rates: example
 Let us first calculate df(1), the discount factors for year 1 (value of
$1 to be received one year from now), df(2), the discount factor for
year 2 (value of $1 to be received two years from now), and df3,
the discount factor for year 3 (value of $1 to be received three
years from now).
1
 𝑑𝑓 1 = 1+4%
= 0.96154
0.96154
 𝑑𝑓 2 = = 0.91575
1+5%
0.91575
 𝑑𝑓 3 = = 0.86392
1+6%

 Then, let us calculate the value of the bond:

 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 3 − 𝑦𝑒𝑎𝑟 𝑏𝑜𝑛𝑑 = $50 × 0.96151 + $50 × 0.91575 +
$1,050 × 0.86392 = $1,00.98
Yield spread measures
 Yield spread: difference between the yields of two different bonds
(usually quoted in basis points).
 Benchmark spread: yield spread relative to a benchmark bond
(example: a 5-year corporate bond has a yield of 6.25% and its
benchmark, the 5-year Treasury note has a yield of 3.50%; the
corporate bond has a benchmark spread of 275 basis points).
 G-spread: yield spread over a government bond.
 Interpolated spread or I-spread: yield spread relative to swap rates.
 Yield spreads are useful for analyzing the factors that affect a
bond’s yield. If a corporate bond’s yield increases, this may have
been caused by i) factors that affect all bond yields, or ii) firm-
specific or industry-specific factors (credit risk, liquidity risk).
Yield spread measures
 Zero-volatility spread or z-spread: amount which
when added to the benchmark spot rates, produces
a value equal to the market price of the bond.

 Option-adjusted spread or OAS: spread to the

Treasury spot rate curve that the bond would have if
it were option-free:
OAS = Z-spread – option value
Example
 1-year, 2-year, and 3-year spot rates on Treasuries are 4%,
8.167%, and 12.377%, respectively.
 Consider a 3-year, 9% annual coupon corporate bond trading at
89.464.
 The YTM is 13.50%, and the YTM of a 3-year Treasury is 12%.
 Compute the G-spread and the Z-spread of the corporate bond.
 G-spread = 13.50% - 12% = 1.50%
9 9 109
89.464 = + +
(1.04 + 𝑍𝑆) (1.08167 + 𝑍𝑆)2 (1.12377 + 𝑍𝑆)3
𝑍𝑆 = 1.67% or 167 basis points
 This spread is found by trial and error.
Introduction to Asset-Backed
Securities
Reading 45

2/3/2021
LOS
a. Explain benefits of securitization for economies and financial markets
b. Describe securitization, including the parties involved in the process and
the roles they play
c. Describe typical structures of securitizations, including credit tranching
and time tranching
d. Describe types and characteristics of residential mortgage loans that are
typically securitized
e. Describe types and characteristics of residential mortgage-backed
securities, including mortgage pass-through securities and collateralized
mortgage obligations, and explain the cash flows and risks for each type
f. Define prepayment risk and describe the prepayment risk of mortgage-
backed securities
g. Describe characteristics and risks of commercial mortgage-backed
securities

2/3/2021
LOS
h. Describe types and characteristics of non-mortgage
asset-backed securities, including the cash flows
and risks of each type
i. Describe collateralized debt obligations, including
their cash flows and risks

2/3/2021
Benefits of securitization
 Securitization: process by which financial assets (mortgages,
accounts receivable, or automobile loans) are purchased by
an entity that then issues securities supported by the cash
flows from those financial assets.

 Compared to the traditional business model in which banks

acts as an intermediary between borrowers and lenders,
securitization can provide the following benefits:
 reduces intermediation costs;
 stronger legal claim to the mortgages or other loans for the
investors;
 increased liquidity of the banks’ assets compared to holding the
loan;
Benefits of securitization
 Compared to the traditional business model in which
banks acts as an intermediary between borrowers
and lenders, securitization can provide the following
benefits:
 banks are able to lend more;
 allows investors to invest in securities that better match
their preferred risk and return characteristics;
 provides diversification compared to purchasing
individual loans.
The securitization process
 Let us illustrate the securitization process with a
simplified example:
The securitization process
Customers buy cars

Fred Motor Company

$1 billion in car loans

(Seller and Servicer) $1 billion in cash

Auto Loan Trust (SPV)

$1 billion in ABS
(Issuer/Trust) $1 billion in cash

Investors
The securitization process
 The parties to this transaction and their functions:
The seller (Fred) originates the auto loans and sells the
portfolio of loans to Auto Loan Trust, the SPV.
The issuer (Trust), Auto Loan Trust, is the SPV that buys
the loans from the seller and issues ABS to investors.
The servicer, Fred Motor Company, services the loans.
The seller and the servicer are the same entity but this
is not always the case.
Residential Mortgage Loans (RMBS)
 RMBS: loan for which the collateral is residential real estate; if the
borrower defaults, the lender has a legal claim to the collateral
property.

 Loan-to-value ratio (LTV): percentage of the value of the collateral

that is loaned to the borrower; for a lender, the higher the LTV, the
[?] the risk.

 Key characteristics:
 Maturity
 Interest rate
 Amortization of principal
 Prepayment
 Foreclosure
Practice question
 A bank’s customer has contracted a convertible
mortgage loan.
 For the customer, this implies that:
a. The interest rate of the loan is fixed for some initial
period, but adjusted after that.
b. The initial interest rate term of the loan can be
changed at the initiative of the lender.
c. The initial interest rate term of the loan could be
changed at the initiative of the borrower.
Key characteristics of Residential
Mortgage Loans
 Amortization of principal
 Fully amortizing loan: each payment includes both an
interest payment and a repayment of some of the loan
principal;

 Partially amortizing loan: loan payments include some

repayment of principal, but there is a lump sum of principal
that remains to be paid at the end of the loan period
which is called a “balloon payment”.

 Interest only mortgage loans: no principal repayment for

either an initial period or the life of the loan.
Key characteristics of Residential
Mortgage Loans
 Prepayment provisions: partial of full repayment of
principal in excess of the schedules principal payments
required by the mortgage loan (may entail a
prepayment penalty)

 Foreclosure
 Non-recourse loan: the lender has no claim against the
assets of the borrower except for the collateral property
itself;
 Recourse loan: the lender has a claim against the borrower.
Types and characteristics of RMBS
 Agency RMBS: issued by the Government National
Mortgage Association (GNMA or Ginnie Mae), the
Federal National Mortgage Association (Fannie
Mae), and the Federal Loan Mortgage Corporation
(Freddie Mac).
 Ginnie Mae securities: backed by the full faith and
credit of the US government.
 Fannie Mae and Freddie Mac: GSEs.
Mortgage pass-through securities
 A mortgage pass-through security represents a claim
against a pool of mortgages.
 Any number of mortgages may be used to form the
pool, and any mortgage included in the pool is
referred to as securitized mortgage.
 Mortgage pass-through securities

Mortgage 1 Investor 1
POOL
Mortgage 2 Investor 2

… Investor M

Mortgage N
Cash flow characteristics of
mortgage pass-through securities
 Pass-through securities investors receive the monthly
cash flows generated by the underlying pool of
mortgages, less servicing and guarantee fees.
 The mortgage servicer receives the payments and
the cash flows are passed through to the securities
holders with a delay.
 A mortgage pool is characterized by a weighted
average coupon rate (WAC) and a weighted
average maturity (WAM).
 Cash flow characteristics of MBS
Mortgage Outstanding Weight % Mortgage rate Remaining
balance % payments in
months

1 $500,000.00 57.14 8.5 350

2 $375,000.00 42.86 6.5 200

Total $875,000.00 100.00

Cash flow characteristics of MBS
 The weighted average coupon rate (WAC) is:
 WAC = 0.5714 x 8.5 + 0.4286 x 6.5 = 7.64%
 The weighed average maturity (WAM) is:
 WAC = 0.5714 x 350 + 0.4286 x 200 ≈ 286
months
Risks of mortgage pass-through
securities
 Contraction risk: refers to the shortening of the
expected life of the mortgage pool due to falling
interest rates and higher prepayment rates.
 Extension risk: associated with interest rates
increases and falling prepayment rates.
Risks of mortgage pass-through
securities
 Like MBS, mortgage pass-through securities are
subjected to prepayment risk as their cash flows are
not known with certainty.
 The only way to project a cash flow is to make some
assumption about the prepayment rate over the life
of the underlying mortgage pool.
Prepayment convention and cash flow

 Estimating the cash flow from a pass-through

requires making an assumption about future
prepayments.
 The CMS industry has defined two important criteria
to qualify prepayment risk:
  the conditional prepayment rate (CPR)
  the Public Securities Association prepayment
benchmark
Conditional prepayment rate (CPR) and
single monthly mortality rate (SMM)
 The conditional prepayment rate is the annual rate
at which a mortgage pool balance is assumed to be
prepaid.
 It can be converted into a monthly rate called the
single monthly mortality rate (SMM) using the
following equation:
 SMM = 1 – (1- CPR)1/12
 Example: an SMM of 10% implies that 10% of the
pool’s balance outstanding at the beginning of the
month is expected to be prepaid during the month.
Single monthly mortality rate (SMM)
and prepayment amount
 Suppose that an investor owns a pass-through in
which the remaining mortgage balance at the
beginning of some month is $290 million.
 Assuming that the SMM is 0.5143% and the
scheduled principal payment is $3 million, the
estimated prepayment for the month is:
 0.005143 x ($290,000,000 - $3,000,000) =
$1,476,041
Conditional prepayment rate and
the PSA prepayment benchmark
 The Public Securities Association has defined a
benchmark measure of prepayment, based on the
assumption that the monthly prepayment rate for a
mortgage pool increases as it ages.
 It is expressed as a monthly series of CPRs:
 CPR = 0.2% for the first month, increasing by 0.2%
per month up to 30 months.
 CPR = 6% per month for months 30 to 360.
Conditional prepayment rate and
the PSA prepayment benchmark
 A particular mortgage pool may exhibit prepayment
rates faster or slower than 100% PSA, depending
on factors such as the coupon rate.
 A 150 PSA refers to 1.5 times the CPR assumed by
the benchmark.
 A 50 PSA refers to half of the CPR assumed by the
benchmark.
Conditional prepayment rate and
the PSA prepayment benchmark
 The CPR and SMM for the 5th month, assuming 100
PSA and 150 PSA are computed as follows:
 5th month CPR = 6% (5/30) = 1%
 100 PSA CPR = 1 x 1% = 1%
 100 PSA SMM = 1 – (1-1%)1/12 = 0.000837 =
0.0837%
 150 PSA CPR = 1.5 x 1% = 1.5%
 150 PSA SMM = 1 – (1-1.5%)1/12 = 0.001259 =
0.1259%
Practice example
 Compute the CPR and SMM for the 25th month,
assuming 100 PSA and 150 PSA.
Practice example
 25th month CPR = 6% (25/30) = 5%
 100 PSA CPR = 1 x 5% = 5%
 100 PSA SMM = 1 – (1- 5%)1/12 = 0.004265 =
0.4265%
 150 PSA CPR = 1.5 x 5% = 7.5%
 150 SMM = 1 – (1- 7.5%)1/12 = 0.006476 =
0.6476%
Maturity and average life of a
mortgage backed security
 Since the scheduled amortization and prepaid
amount will tend to accelerate the redemption of
principal, the average life of a mortgage-backed
security is a more relevant measure than the
security’s maturity.
Practice example
 Assume that you have invested in a mortgage pool
with a $100,000 principal balance outstanding at
the beginning of the 25th month.
 The scheduled monthly principal payment for month
25 is $28.61.
 Assuming 100% PSA, compute the prepayment for
the 25th month.
Practice example
 25th month CPR = 6% (25/30) = 5%
 100 PSA CPR = 1 x 5% = 5%
 100 PSA SMM = 1 – (1- 5%)1/12 = 0.004265 =
0.4265%
 Prepayment amount = ($100,000 - $28,6) x
0.4265% = $426.38
Factors that affect prepayment
 The factors that affect prepayment behavior are:
1. Prevailing mortgage rate
2. Characteristics of the underlying mortgage pool
3. Seasonal factors
4. General economic activity
Agency and non-agency
mortgage-backed securities
 The Agency mortgage-backed securities are backed
by residential mortgage loans issued by agencies of
the federal government.
 The loans included in the mortgage pool of an
agency security must conform to the underwriting
standards of the issuing or guaranteeing agency.
 The non-agency securities, issued by private entities,
are backed by loans that fail to meet the agency’s
underwriting standards.
Agency and non-agency
mortgage-backed securities
 Cash flows from non-agency securities are affected
by mortgage default rates.
 Consequently, the risk and expected return of non-
agency issues is higher than agency issues.
Asset-backed securities and credit
enhancement
 Credit enhancement come in two forms:
 External

 Internal
External credit enhancement
 Financial guarantees from third parties that support
the performance of the bond.
 Used to supplement other forms of credit
enhancements.
 Often provided by a monoline insurance company, a
private insurance company that only provides
insurance for financial instruments (municipal bonds
and various ABS and MBS).
Internal credit enhancement
 The most common forms of internal credit
enhancements are reserve funds, overcollateralization,
and senior/subordinated structures.
Reserve funds
 Come in two forms: cash reserve funds and excess
servicing spread accounts.
 Cash reserve funds:
 Straight deposits of cash generated from issuance proceeds.
 Part of the underwriting profits from the deal are deposited into
a fund which typically invests in money market instruments.
 Cash reserve funds are typically used in conjunction with external
credit enhancements.
Excess servicing spread accounts

 Involve the allocation of excess spread or cash into a

separate reserve account after paying out the net
coupon, servicing fee, and all other expenses on a
monthly basis.
 Example:
 The gross weighted average coupon (paid by borrowers) is 8%.
 The net weighted average coupon is 7.25% (paid to investors),
and servicing and other fees are 0.25%.
 8% is available to make payments to the tranches, to cover
servicing fees, and to cover other fees.
 0.25% is paid for servicing and other fees and 7.25% is paid to
the tranches.
 Only 7.5% must be paid out, leaving 0.5%.
 This 50 basis points is called the excess servicing spread.
Overcollateralization
 The amount of the collateral must be at least equal
to the amount of the liability.
 If the amount of the collateral exceeds the amount
of the liability of the structure, the deal is said to be
overcollateralized.
 For example, if the liability of the structure is $100
million and the collateral’s value is $105 million, then
the structure is overcollateralized by $5 million.
 Thus the first $5 million of losses will not result in a
loss to any of the tranches.
Senior/subordinated structure
 The most popular form of credit enhancement is the
senior-subordinated structure.
 In this structure, there is a senior tranche and at least
one junior or subordinated tranche.
 For example, the structure may look as follows:
 Seniortranche: $280 million
 Subordinated tranche: $20 million

 The first $20 million of losses are absorbed by the

subordinated tranche.
Senior/subordinated structure
 The structure can have more than one subordinated tranche.
 For example, the structure can be as follows:
 Senior tranche: $300 million
 Subordinated tranche A: $80 million
 Subordinated tranche B: $30 million
 In this structure, the subordinated tranches A and B are called
the non-senior tranches and the first $30 million of losses is
absorbed by the subordinated tranche B.
 Hence this tranche is referred to as the first loss tranche.
 Subordinated tranche A has protection of up to $30 million in
losses, the protection provided the first loss tranche.
Shifting interest mechanism
 The level of credit protection changes over time due to
prepayments.
 The objective is to distribute any prepayments such that the
credit protection for the senior tranche does not deteriorate
over time.
 The mechanism to address this concern is called the shifting
interest mechanism.
 The purpose of a shifting interest mechanism is to allocate
prepayments so that the subordinate interest is maintained at
an acceptable level to protect the senior tranche.
 The amount of subordination is maintained by paying down
the senior tranche more quickly,
Shifting interest mechanism
 A commonly used shifting interest percentage is as
follows:
Year after issuance Senior prepayment
percentage
1-5 100
6 70
7 60
8 40
9 20
After 9 0
Shifting interest mechanism
 The prospectus will provide the shifting interest
percentage schedule for calculating the percentage
of prepayments paid to the senior tranche.
 The shifting interest mechanism reduces the credit risk
to the senior tranche.
 However, because the senior tranche receives a
larger share of any prepayments, contraction risk
increases.
Creation of collateralized mortgage
obligation (CMOs)
 CMOs are created by issuing securities against pass-
through securities for which the cash flows have been
reallocated to different bond classes called
tranches, each having a different claim against the
cash flows of the mortgage pass-through.
 Each tranche bears a different exposure to
contraction and extension risk.
 The securities created more closely satisfy the
asset/liability needs of institutional investors.
Sequential pay tranches
 A sequential pay CMO is a structure with several
tranches in which all tranches receive interest
payments at a specified coupon rate, but all
principal payments are directed sequentially to each
tranche until completely amortized.
Practice example
 Consider a simplified CMO structure in which
repayments of principal from the underlying
collateral are allocated first to tranche A and then
to tranche B:
 Tranche A:
 Outstanding principal = $200 million
 Coupon rate = 8.5%

 Tranche B:
 Outstanding principal = 50 million
 Coupon rate = 8.5%.
Payments from underlying pool
Month Beginning principal balance Principal Interest Total cash flow

1 $250,000,000 $391,128 $1,770,833 $2,161,961

2 249, 608,872 454,790 1,768,063 2,222,853
3 249,154,082 518,304 1,764,841 2,283,145
4 248,635,778 581,620 1,761,170 2,342,790
5 248,054,157 644,690 1,757,050 2,401,741
…
183 $51,491,678 $545,153 $364,733 $909,886
184 50,946,525 540,831 360,871 901,702
185 50,405,694 536,542 357,040 893,582
186 49,869,152 532,287 353,240 885,526
187 49,336,866 528,065 349,469 877,534
Payments to tranche A
Month Beginning principal balance Principal Interest Total cash flow

1 $200 000 000 391 128 1 416 667 1 807 795

2 199 608 872 454 790 1 413 896 1 868 686
3 199 154 082 518 304 1 410 675 1 928 979
4 198 635 778 581 620 1 407 003 1 988 623
5 198 054 158 644 690 1 402 884 2 047 574
…
183 $1 491 678 545 153 10 566 555 719
184 946 525 540 831 6 705 547 536
185 405 694 405 694 2 874 408 568
186 0 0 0 0
187 0 0 0 0
Payments to tranche B
Month Beginning principal balance Principal Interest Total cash flow

1 $50 000 000 0 354 167 354 167

2 50 000 000 0 354 167 354 167
3 50 000 000 0 354 167 354 167
4 50 000 000 0 354 167 354 167
5 50 000 000 0 354 167 354 167
…
183 $50 000 000 0 354 167 354 167
184 50 000 000 0 354 167 354 167
185 50 000 000 130 848 354 167 485 015
186 49 869 152 532 287 353 240 885 527
187 49 336 865 528 065 349 469 877 534
Planned amortization class tranche
(PAC) and support tranche
 Another CMO structure has one or more planned
amortization class (PAC) tranches and support tranches.
 A PAC tranche is structured to make predictable
payments, regardless of actual payments to the MBS.
 A PAC tranche is packaged with a support tranche:
 If prepayment rates are faster than the upper repayment
rate, the PAC tranche receives principal according to the
PAC schedule and the support tranche receives the excess.
 If prepayment rates are below the lower repayment rate,
the funds needed to keep the PAC on schedule come from
the cash flows of the support tranche.
Initial PAC collar
 For a given CMO, there are limits to how fast or slow
actual prepayments can be before the support
tranches can no longer either provide or absorb
prepayments in the amounts required to keep the
PAC payments to their scheduled amounts.
 The upper and lower bounds on actual prepayments
for which the support tranches are sufficient to either
provide or absorb actual prepayments are called
the initial PAC collar.
Practice example
 PAC repayment schedule, assuming prepayment
rates of 90 PSA and 300 PSA: PAC principal
payments are equal to the lesser amount prescribed
by the 90 PSA and the 300 PSA repayment
schedules.
PAC repayment schedule, assuming
prepayment rates of 90 PSA and 300 PSA
Month 90% PSA 300% PSA PAC repayment
schedule
1 508,169.52 1,075,931.20 508,169.52
2 569,843.43 1,279,412.11 569,843.43
… … … …
101 1,458,719.34 1,510,072.17 1,458,719.34
102 1,452,725.55 1,484,126.59 1,452,725.55
… … … …
211 949,482.58 213,309.00 213,309.00
… … … …
346 618,684.59 13,269.17 13,269.17
PAC repayment schedule, assuming
prepayment rates of 90 PSA and 300 PSA
 The PAC will make its scheduled payments to
investors unless actual prepayment experience is
outside these bounds (above 300 or below 90 PSA).
 If the prepayment rate is outside of these bounds,
the PAC tranche is referred to as a broken PAC.
 Support tranches have both more contraction risk
and more extension risk than the underlying MBS.
Characteristics and risks of commercial
mortgage-backed securities
 Commercial mortgage-backed securities (CMBS): backed by
income-producing real estate, typically in the form of:
 Apartments (multi-family)
 Warehouses (industrial use property)
 Shopping centers
 Office buildings
 Health care facilities
 Senior houses
 Hotel/resort properties
 CMBS mortgages are structured as nonrecourse loans,
meaning the lender can only look for the collateral as a mean
to repay a deliquent loan if the cash flows from the property
are insufficient.
Characteristics and risks of commercial
mortgage-backed securities
 The analysis of CMBS focuses on the credit risk of the
property and not on the credit risk of the borrower.
 The analysis focuses on two key ratios to assess credit risk:
 Debt-to-service coverage ratio = net operating income / debt
service
 Net operating income (NOI) is calculated after the deduction for real
estate taxes but before any relevant income taxes.
 Typically between 1 and 2, indicates greater protection when it is
higher.
 Loan-to-value ratio = current mortgage amount / current
appraised value
 Determines the amount of collateral available to provide a cushion to
the lender should the property be foreclosed on and sold.
Types and characteristics of non-
mortgage backed securities
 ABS that are backed by various types of financial
assets, including:
 small business loans,
 accounts receivable,
 credit card receivables,
 automobile loans,

 home equity loans, and

 manufactured housing loans.
Auto Loan ABS
 Auto Loan ABS: backed by loans for automobiles.
 Auto loans have maturities from 36 to 72 months.
 Issued by: financial subsidiaries of auto manufacturers,
commercial banks, credit unions, finance companies, and other
small financial institutions.
 Cash flow components: interest payments, scheduled principal
payments, and prepayments.
 Credit enhancements: senior-subordinated structures, with a
junior tranche that absorbs credit risk, reserve accounts,
excess interest spread, overcollateralization.
 Prime loans: made to borrowers with higher credit ratings.
 Sub-prime loans: made to borrowers with low credit ratings.
Credit Card ABS
 Credit card ABS: backed by pools of credit card debt owed to
banks, retailers, travel and entertainment companies, and other
credit card issuers.
 Cash flows: finance charges, annual fees, and principal repayments.
 Principal repayments: credit card have periodic repayment
schedules, but because their balances are revolving, the principal
amount is maintained.
 Lockout period: period lasting from 18 months to 10 years after the
ABC creation during which no principal is paid to ABS holders. If the
underlying pool makes principal payments during this period, the
payments are used to purchase additional credit card receivables,
keeping the overall value of the pool constant. Once the lockout
period ends, payments are passed through the holders.
Types and characteristics of
collateralized debt obligations (CDOs)
 CDOs: structured security issued by an SPV for which the collateral is a
pool of debt obligations.
 CBOs: the collateral securities are corporate and emerging market debt.
 CLOs: the collateral pool is a portfolio of leveraged bank loans.
 Collateral manager: buys and sells securities in the collateral pool in order
to generate the cash to make the promised payments to investors.
 Structured CDOs: the collateral is ABS, RMBS, other CDOs, and CMBS.
 Synthetic CDOs: the collateral is a portfolio of credit default swaps on
structured securities.
 Even though CDOs are issued by an SPV, they are not considered ABS
because of this difference in the source of cash flows promised to investors.
Types and characteristics of
collateralized debt obligations (CDOs)
 CDOs typically issue three classes of bonds: senior
bonds, mezzanine bonds, and subordinated bonds
(equity tranche).
 Subordinated tranche:
 Has characteristics more similar to those of equity
investment than bond investments.
 Can be viewed as a leveraged investment where borrowed
funds (raised from selling the senior and mezzanine
tranches) are used to purchase the debt securities in the
collateral pool.
 earning returns in excess of borrowing costs are paid to the
CDO manager and the equity tranche.