Chapter 22 FixedIncome Securities

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Chapter 22Fixed-Income Securities

• Fabozzi Investment Management
• Graphics by

2
Learning Objectives

• You will discover the different types of
  fixed-income securities.
• You will understand the fundamental features of
  bonds.
• You will learn about the different types of
  securities issued by the Treasury.
• You will be able to show how zero-coupon Treasury
  securities are created.
• You will study the provisions for paying off a
  corporate bond issue prior to the maturity date.
• You will investigate the different credit ratings
  for a corporate bond issue.

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Learning Objectives

• You will understand the two types of municipal
  bonds general obligation bonds and revenue
  bonds.
• You will be able to identify types of securities
  issued in the Eurobond market.
• You will discover the characteristics of
  preferred stock.
• You will study the cash flow characteristics of a
  mortgage loan and the meaning of prepayment risk.
  
• You will explore the three types of
  mortgage-backed securities mortgage pass-through
  securities, collateralized mortgage obligations,
  and stripped mortgage-backed securities.
• You will investigate the different types of
  asset-backed securities.

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Introduction

• In this chapter we turn to another major asset
  class, fixed-income securities. We will describe
  basic features and then discuss the variety of
  investment vehicles available in this asset
  group. This serves as an introduction to the rest
  of Section V.

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Bond fundamentals

• Some definitions
• Fixed income security issuer (borrower) agrees
  to make income payments fixed by contract
• Bonds (debt obligations) borrower makes
  interest payments
• Preferred stock an equity issue with fixed
  income payments of dividends
• Term to maturity date when debt ceases, with
  maturity being that exact date and term denoting
  the number of years till that date
• Par value (maturity value, face value) amount
  issuer agrees to pay at maturity
• Coupon periodic interest payment made to
  bondholders
• Coupon rate rate of interest usually paid
  semiannually for U.S. issues multiplied by par
  value yields dollar value of coupon

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Bond fundamentals

• Zero-coupon bonds no periodic interest
  payments principal and interest paid at term
• Floating rate security coupon rate is reset
  periodically
• Insert Table 22-1

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U.S. Treasury securities

• Bills matures in one year or less, issued at a
  discount
• Notes matures between 2-10 years, issued as a
  coupon security
• Bonds maturities longer than 10 years
• Treasury inflation protection securities (TIPS)
  principal is indexed to CPI- U with real rate
  being fixed

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Quotation convention for Treasury bills

• Quotes are in terms of yield, not price
• Yield on bank discount Yd D x 360
• F t
• Yd annualized yield on a bank discount basis
  (expressed as a decimal)
• D dollar discount, which is equal to the
  difference between the face value and the
  price
• F face value
• t number of days remaining to maturity
• Example
• T 100, F 100,000, Price 97,569
• D 100,000 97,569 2,431
• Yd 2,431 x 360 8.75
• 100,000 100

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Price quotation convention for Treasury coupon
securities

• Notes and bonds trade on a dollar price basis in
  unites of 1/32 of 1 of par (100).
• Example
• Quote of 92-14 92 and 14/32 with a basis of
  100,000 par value a change in price of 1
  1000 with 1/32 31.25.

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Stripped Treasury securities

• Several major brokerages have created an
  investment vehicle from Treasury securities.
  They purchase these securities, deposit them in a
  bank custody account and then separate out each
  coupon payment and principal. Then a receipt is
  issued to investors representing an ownership in
  the account. In essence, the security is
  stripped.
• Trademark zero-coupon - Treasury securities refer
  to the firm they are associated with.
• Treasury receipts (TRs) generic receipts issued
  by a group of primary dealers in the government
  market representing ownership of a Treasury
  security

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Stripped Treasury securities

• STRIPS U.S. Treasury program issues these
  direct obligations of the U.S. government, ending
  trademark and generic receipts
• Treasury strips - zero-coupons or stripped
  Treasury securities
• Treasury coupon strips created from the future
  coupon
• Treasury principal strips - created from the
  principal
  payment at maturity

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Federal agency securities

• There are two categories of federal agency
  securities
• Government-sponsored enterprises securities
  market
• Federally related institutions securities markets

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Federally related institutions securities

• While a number of arms of the federal government
  are allowed to issue securities directly in the
  marketplace, only the Tennessee Valley Authority
  (TVA) has done so recently. These issues are
  backed by the full faith and credit of the U.S.
  government.

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Government-sponsored enterprise securities

• Federal Farm Credit Bank System
• Farm Credit Financial Assistance Corporation
• Federal Home Loan Bank
• Federal Home Loan Mortgage Corporation
• Federal National Mortgage Association
• Student Loan Marketing Association
• Financing Corporation (FDIC)
• Resolution Trust Corporation
• Except for farm related securities, these are not
  backed by the
• U.S. government.

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Corporate bonds

• The issuer agrees to make coupon payments and
  repay the principal value of the bond at
  maturity. If the institution cannot pay, it is
  in default. Bondholders have first claim to the
  income and assets of a corporation.
• Embedded option options are embedded in the
  bond issue
• Bare option trades separately from the
  underlying security
• Term bonds (bullet) can be retired by payment
  at final maturity or paid off earlier if so
  stated in the bond indenture or contract
• Serial bonds specified principal amounts are
  due on specified dates
• Medium-term notes continuously offered to
  investors over a period of time

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Security for bonds

• Beyond the general credit standing, real or
  personal property may be pledged.
• Insert Table 22-2

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Provisions for paying off bonds

• Call provision issuer can buy back all or part
  of the issue prior to maturity
• Various types
• Call and refund provisions
• Sinking-fund provision
• Convertible and exchangeable bonds
• Issues of debt with warrants
• Putable bonds
• Floating-rate securities
• Special features in high-yield bonds

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Call and refund provisions

• Call provision
• Issuers want to be able to take advantage of
  falling interest rates in the future (i.e.
  lower their debt costs) and call provisions are
  an embedded option for the issuer. Corporate
  bonds are usually callable at a premium above
  par with the amount declining as the bond
  approaches maturity, often reaching par after a
  certain number of years have passed since
  issuance.
• Refunding
• Issuer cannot redeem bonds during first 5-10
  years following issue unless the funds come
  from other than lower-interest cost money (cash
  flow, common stock sale proceeds).

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Sinking-fund provision

• Indenture requires issuer to retire a specified
  portion of an issue each year in order to reduce
  credit risk
• if only part is paid, remainder is a balloon
  maturity
• Sinking fund can be satisfied by
• -Making a cash payment of the face amount of the
  bond to be retired to the corporate trustee who
  then calls bonds using a lottery system
• Delivering bonds to the trustee with a total face
  value amount that must be retired from bonds
  purchased in the open market
• Embedded option issuer can accelerate repayment
  of principal

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Convertible and exchangeable bonds

• Convertible bonds Bondholder has the right to
  convert the bond to a predetermined amount of
  common stock of the issuer
• Exchangeable bonds bondholder has the right to
  exchange the bonds for common stock of a firm
  other than issuer

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Issues of debt with warrants

• Warrants may allow holder the
• -Right to purchase a designated security at a
  specified price
• -Right to purchase the common stock of the
  debt issuer or another firm
• -Right to purchase a debt obligation of the
  issuer
• Warrants can be sold separately from the bond

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Putable bonds and floating rate securities

• Putable bonds
• Bondholder can sell the issue back to the issuer
  at par value on designated dates
• If interest rates rise after bond is issued,
  which lowers the bond value, the bondholder
  can put the bond to the issuer for par
• Investor receives
• 1.Non-putable corporate bond and
• 2.Long put option on the bond
• Floating-rate securities
• Coupon interest is reset periodically based on
  some contrived interest rate (i.e. spread over
  Treasury bill

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Special features in high-yield bonds

• High-yield or junk bonds have a rating below
  triple B. When used for an LBO or
  recapitalization, where cash flow is severely
  restricted, deferred coupon structures are
  created.
• Deferred interest bonds
• sell at deep discount and do not pay interest for
  3 7 years
• Step-up bonds
• low coupon rate for initial period and then
  increases to a higher rate for the remainder of
  the term
• Payment-in-kind (PIK) bonds
• issuer can pay cash at a coupon date or give the
  bondholder a similar bond equal to the amount of
  the cash payment

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Credit ratings

• Insert Table 22-3
• Ratings apply to the issue, not the issuer and
  are an opinion as to the issuers ability to meet
  its obligations.

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Municipal securities

• These debt obligations are issued by state and
  local governments. Their structures are either
  serial maturity or term maturity.
• Serial maturity portion of the debt is retired
  each year
• Term maturity - debt is retired in maturities
  ranging from 20-40 years with sinking fund
  provisions beginning 5 10 years prior to
  maturity
• Types of municipal securities
• General obligation bonds
• Revenue bonds
• Hybrid bonds

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General obligation bonds

• Many general obligation bonds are secured by the
  issuers unlimited taxing power.
• Limited-tax general obligation bonds - backed by
  taxes that are limited as to revenue source
• Full faith and credit obligations used by
  larger issuers who have access to taxes beyond
  property taxes
• Double-barreled revenue source includes fees,
  grants, etc. as well as taxing power

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Revenue bonds

• These are bonds issued for project or enterprise
  financings where the revenues from the project
  are promised to the bondholders. Examples
  include airports, universities, sports complex
  bonds and water revenue bonds.
• All revenues from the enterprise are placed in a
  revenue fund with disbursements to funds covering
  
• -operation and maintenance fund
• -sinking fund
• -debt service reserve fund
• -renewal and replacement fund
• -reserve maintenance fund
• -surplus fund

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Hybrid bond securities

• Insured bonds backed by insurance policies
  written commercially in addition to the credit of
  municipal issuer
• Refunded bonds (prerefunded bonds) originally
  issued as G.O. or revenue bonds but are now
  secured by an escrow fund consisting of U.S.
  government obligations

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Eurobonds

• A Eurobond is
• 1.underwritten by an international syndicate
• 2.offered, at issuance, simultaneously to
  investors in a number of countries
• 3.issued outside the jurisdiction of any single
  country
• 4.mostly traded in OTC market
• Euro straights fixed-rate coupon bond with
  annual coupons
• Dual currency issues interest and principal are
  paid in different currencies
• Convertible Eurobond can be converted to
  another asset
• Many Eurobonds trade with attached warrants.

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Preferred stock

• Preferred stock is not a debt instrument, but a
  senior security with dividends set at a
  percentage of par value (dividend rate).
• -Dividends are a distribution of earnings.
  However, 70 of this income is exempt from
  federal taxation if the recipient is a qualified
  corporation.
• -Promised returns to holders of preferred are
  fixed
• -Preferred holders have priority over common
  stockholders for dividends and liquidation
  distributions
• Cumulative preferred if issuer cannot make a
  payment, the dividend accrues until fully paid
• Non-cumulative preferred if issuer cannot make
  a payment, owner forgos the payment
• Perpetual preferred issues without a maturity
  date

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Mortgages and mortgage-backed securities

• Mortgage market is the largest sector of the
  fixed-income market, and includes mortgage-backed
  securities such as
• -Mortgage pass-through securities
• -Collateralized mortgage obligations
• -Stripped mortgage-backed securities

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Mortgages

• A mortgage is a loan secured by the collateral of
  some specified real estate property which obliges
  the borrower to make a predetermined series of
  payments. The lender can foreclose on the
  borrower is the debt is paid.
• Interest rate mortgage rate
• Conventional mortgage loan is based on the
  credit of the borrower and the collateral for the
  mortgage (a residence).

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Cash flow characteristics of a mortgage loan

• Level-payment mortgage
• Borrower pays interest and principal in equal
  installments over a set period (maturity/term
  of mortgage) Each monthly payment consists of
• 1.Interest of 1/12th of the fixed annual
  mortgage rate times the amount of the
  outstanding mortgage balance at the beginning
  of the previous month
• 2.A repayment of a portion of the principal
• The portion of the monthly payment applied to the
  interest declines each month, while the payment
  towards principal increases. This describes a
  self-amortizing loan.
• Insert Table 22-4

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Mortgage cash flow with servicing fee

• Servicing responsibilities include
• Collecting monthly payments
• Forwarding proceeds to owners of the loan
• Sending payment notices to mortgagors
• Maintaining records of principal balances
• Maintaining escrow accounts for property taxes
  and insurance
• Initiating foreclosure proceedings
• Cash flow from loan goes to
• 1.servicing fee
• 2.interest payment net of servicing fee
• 3.scheduled principal repayment

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Prepayments and cash flow uncertainty

• Loan holders can, and do, pay off mortgages early
  by making prepayments (payments scheduled
  payments) making cash flow uncertain. This
  occurs when
• -Homes are sold
• -If market rates fall, there is incentive to pay
  off the higher mortgage loan.
• -Repossessed property
• -Destroyed property insurance pay off the
  mortgage

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Mortgage pass-through securities

• A pass-through is created when mortgage holders
  form a collection or pool of mortgages and sell
  shares in the pool. This securitization causes
  payments to be made to shareholders each month.
• pass-through coupon rate servicing fees
• Due to cash flow uncertainty, the prepayment
  speed is variable.
• Insert Figure 22-1
• Insert Figure 22-2

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Types of pass-throughs

• Agency pass-throughs
• -Government National Mortgage Association
  (Ginnie Mae)
• -Federally related institution, so is based on
  full faith and credit of U.S. government
• -Federal Home Loan Mortgage Corporation (Freddie
  Mac)
• -Federal National Mortgage Association (Fannie
  Mae)
• Agency can guarantee two ways
• -Fully modified - timely payment of both
  interest and principal
• -Modified - timely payment of interest only,
  with principal payment simply
  guaranteed
• Non-agency pass throughs
• -Conventional pass throughs
• -Private-label pass-throughs

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Collateralized mortgage obligations (CMO)

• CMO - a security backed by a pool of
  pass-throughs
• Several classes of bondholders (tranches) with
  varying maturities
• Principal payments from the underlying are used
  to retire bonds
• Set rules for prioritizing the distribution of
  principal payments among tranches
• Prepayment risk is distributed among the
  tranches, lowering cash flow uncertainty
• Insert Figure 22-3

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Stripped mortgage-backed securities

• Instead of dividing the cash flow from the
  underlying pool on a pro rata basis, stripped
  mortgage-backed securities distribute the
  principal and interest unequally.
• Principal and interest are divided between two
  classes unequally.
• Insert Figure 22-4

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Asset-backed securities

• Securities backed by
• Credit card receivables
• Auto loans
• Home equity loans
• Manufactured housing loans
• These account for about 95 of the total market.

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Credit risk

• In analyzing the risk of asset-backed securities
  we focus on
• 1.Credit rating of the collateral
• 2.Quality of the seller/servicer
• 3.Cash flow stress and payment structure
• 4.Legal structure

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Credit quality of the underlying collateral

• Ratings companies look at the following
• -Borrowers ability to pay
• -Borrowers equity in the asset
• -The experience of originators of the loan vs.
  the reported experience
• Concentration risk credit risk lessened by more
  borrowers in the pool (diversification). Rating
  companies can set concentration limits on the
  amount of receivables from any one borrower.
• Credit enhancement provides greater protection
  against losses due to borrower defaults.
• External insurance, corporate guarantees,
  letters of credit, cash collateral reserves
• Internal reserve funds, senior/subordinated
  debentures

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Quality of the seller/servicer

• Loan originator or financial institution
  establishes underwriting standards, with the
  rating agencies evaluating the servicer of the
  loans. Issues include
• 1.Servicing history
• 2.Experience
• 3.Originations
• 4.Servicing capabilities
• 5.Human resources
• 6.Financial condition
• 7.Growth/competition/business environment

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Cash flow stress and payment structure

• Cash flow interest and principal repayment
• Payment structure
• Payment priorities
• Amortization of bond principal repayments
• How excess cash flow is used
• Depends on type of collateral
• Rating companies analyze structure to determine
  if the collaterals cash flow meets the necessary
  payments.

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Legal structure

• Bankruptcy-remote special purpose corporation
  (SPC)
• SPC is the issuer of the asset-backed security
  underlying loans are used for collateral for a
  debt instrument rater than general credit of
  issuer with the corporate entity retaining some
  interest. If the issuer enters bankruptcy, the
  SPC will avert a bankruptcy court consolidation
  of the collateral with the assets of the seller.
  
• SPC is a wholly-owned subsidiary of the seller of
  the collateral.
• Collateral sold to SPC
• SPC sells to the trust
• Trust holds collateral for investors
• SPC hold the interest retained by seller of
  collateral

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Cash flow of asset-back securities

• Collateral is either amortizing or non-amortizing
• Amortizing assets borrowers payments consists
  of scheduled principal and interest payments
  over life of loan (auto, home equity,
  residential)
• Non-amortizing assets no payment schedule
  borrower makes minimum periodic payment (credit
  card receivables, some home equity loans)
• payment loan balance
• payment interest on loan balance applied to
  reduction of balance
• Prepayments are projected based on changes in
  interest rates and refinancing prospects,
  estimated default rates and the recovery rate.

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Types of asset backed securities

• Auto loan
• Credit card receivable-backed securities
• Home equity loan-backed securities
• Manufactured housing-backed securities

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Auto loan

• Issued by
• Financial subsidiaries of auto manufacturers
• Commercial banks
• Independent finance companies
• Cash flow
• Scheduled monthly loan payments (interest and
  principal) amortized
• Prepayments resulting from
• Sales and trade-ins requiring full pay off
• Repossession and resale
• Loss or destruction of vehicle
• Cash payoff to save on interest cost
• Refinancing of loan at lower interest cost

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Auto loan

• Pass through structure senior tranche and
  subordinated trance with an interest-only class
  (used for smaller deals)
• Pay through structures senior pieces tranched
  to create a range of lives with untranched
  subordinated piece (larger deals)
• Credit enhancement
• Senior/subordinated structure cash reserves or
  overcollateralization

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Credit card receivable-backed securities

• Issued by
• Banks, retailers, travel and entertainment
  companies
• Cash flow
• Net interest, principal, finance charges
• Interest to security holders paid periodically
  (fixed or floating)
• Lockout (revolving) period principal payments
  made by credit card borrowers in the pool are
  retained by trustee and reinvested in more
  receivables.
• Principal-amortization period - after lockout
  period (18 months 10 years), principal is paid
  to investors.
• Early amortization occurs if trust is not able
  to generate enough income to cover coupon and
  fees, default of services, issuer violates
  pooling and servicing agreements

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Credit card receivable-backed securities

• Amortization structures
• Pass-through princiapl from accounts paid to
  secuity holders on a pro rata basis
• Controlled-amortization scheduled principal
  amount established
• Bullet payment amount distributed in a lump
  sum, with principal paid to a trustee monthly
  into an interest generating account for an
  accumulation period
• Credit enhancement
• Cash collateral account
• Collateral invested account

52
Home equity loan-backed securities

• Home equity loan (HEL) backed by residential
  property, usually a second lien
• Closed end similar to fully amortizing
  residential mortgage loan
• Open end homeowner has credit line up to the
  amount of equity in the property
• Cash flow
• Net interest, scheduled principal payments,
  prepayments
• Prepayments add uncertainty to the cash flow.

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Manufactured housing-backed securities

• Issued by Ginnie Mae and private entities, these
  securities are backed by loans for manufactured
  homes (mobile homes).
• Ginnie Mae loans are guaranteed by FHA or VA
• Other issuers, such as Green Tree Financial, make
  conventional loans and make conventional
  manufactured housing backed securities.
• Loans last 15-20 years with fully amortized loan
  repayment.
• Cash flow
• Net interest, scheduled principal payments,
  prepayments
• Prepayments are more stable since the loan
  balances are small, making refinancing imprudent.
  Also, the rate of depreciation is high in the
  earlier years making it harder to refinance the
  loan.