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Fixed Income 3

Fixed Income 3. Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html. Government-Sponsored Enterprises. Fannie Mae “benchmark” and Freddie Mac “reference” notes and bond. Can be electronically transferred through clearing houses as Euroclear and Cedel and NBES.

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Fixed Income 3

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  1. Fixed Income 3 Zvi Wiener 02-588-3049 http://pluto.mscc.huji.ac.il/~mswiener/zvi.html Fixed Income

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

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

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

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

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

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

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

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

  10. Rating Moody’s S&P Fitch D&P Aaa AAA AAA AAA Aa1 AA+ AA+ AA+ Aa2 AA AA AA Aa3 AA- AA- AA- A1 A+ A+ A+ A2 A A A A3 A- A- A- FI - 3

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

  12. One year transition matrix Aaa Aa A Baa Ba B C&D Aaa 91.9 7.38 0.72 0 0 0 0 Aa 1.1 91.3 7.1 0.3 0.2 0 0 A 0.1 2.6 91.2 5.3 0.6 0.2 0 Baa 0 0.2 5.4 87.9 5.5 0.8 0.2 FI - 3

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  29. Yield on Municipal Bonds tax-exempt yield equivalent taxable yield = 1-marginal tax rate for example bond offers 6.5% and marginal tax rate 40%: 0.065 = 0.1083 1-0.40 FI - 3

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

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

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

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

  34. Comparing Yields bond equivalent yield of Eurodollar bond = 2[(1+yield to maturity)0.5-1] for example: A Eurodollar bond with 10% yield has the bond equivalent yield of 2[1.100.5-1] = 9.762% FI - 3

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

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

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

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

  39. Internet sites • www.federalreserve.gov/releases • www.tradeweb.com • www.bondclick.com • www.fxall.com • www.atriax.com • www.convertbond.com • www.bondsonline.com • www.bba.org.uk FI - 3

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

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

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

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

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

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

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

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

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

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

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

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