financial securities

8/14/2019 financial securities

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Chapter 22

Fixed-Income Securities

Fabozzi: Investment Management

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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 securitiesissued 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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Introduction

In this chapter we turn to another major asset class,fixed-income securities. We will describe basicfeatures and then discuss the variety of investmentvehicles available in this asset group. This serves as anintroduction to the rest of Section V.


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Bond fundamentalsZero-coupon bonds no periodic interest payments;

principal and interest paid at termFloating rate security coupon rate is reset periodically

Insert Table 22-1


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U.S. Treasury securitiesBills 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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Price quotation convention forTreasury coupon securities Notes and bonds trade on a dollar price basis in unites of1/32 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 securitiesSeveral major brokerages have created an investment

vehicle from Treasury securities. They purchase thesesecurities, deposit them in a bank custody account and thenseparate out each coupon payment and principal. Then areceipt 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 agroup of primary dealers in the government marketrepresenting ownership of a Treasury security


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Stripped Treasury securitiesSTRIPS U.S. Treasury program issues these directobligations of the U.S. government, ending trademarkand generic receipts

Treasury strips - zero-coupons or stripped Treasurysecurities

Treasury coupon strips created from the futurecoupon

Treasury principal strips - created from the principal payment at maturity


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Federally related institutionssecuritiesWhile a number of arms of the federal government areallowed to issue securities directly in the marketplace,only the Tennessee Valley Authority (TVA) has done sorecently. These issues are backed by the full faith andcredit 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 principalvalue of the bond at maturity. If the institution cannot pay, it is indefault. Bondholders have first claim to the income and assets of acorporation.

Embedded option options are embedded in the bond issueBare option trades separately from the underlying securityTerm bonds (bullet) can be retired by payment at final maturity

or paid off earlier if so stated in the bond indenture or contractSerial bonds specified principal amounts are due on specifieddatesMedium-term notes continuously offered to investors over a

period of time


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Provisions for paying off bonds

Call provision issuer can buy back all or part of theissue prior to maturityVarious typesCall and refund provisionsSinking-fund provisionConvertible and exchangeable bondsIssues of debt with warrantsPutable bondsFloating-rate securitiesSpecial features in high-yield bonds


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Call and refund provisionsCall provision

Issuers want to be able to take advantage of falling interestrates 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 approachesmaturity, often reaching par after a certain number of yearshave passed since issuance.

RefundingIssuer cannot redeem bonds during first 5-10 yearsfollowing issue unless the funds come from other thanlower-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 issueeach year in order to reduce credit riskif 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 bondsusing a lottery system

-Delivering bonds to the trustee with a total face value =amount that must be retired from bonds purchased in theopen 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 exchangethe 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 aspecified price

-Right to purchase the common stock of the debtissuer 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 ratesecuritiesPutable bonds Bondholder can sell the issue back to the issuer at par value ondesignated 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 receives1.Non-putable corporate bond and

2.Long put option on the bondF loating-r ate secur iti esCoupon interest is reset periodically based on some contrivedinterest rate (i.e. spread over Treasury bill


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Credit ratings

Insert Table 22-3

Ratings apply to the issue, not the issuer and arean opinion as to the issuers ability to meet itsobligations.


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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 yearTerm maturity - debt is retired in maturities ranging from

20-40 years with sinking fund provisions beginning 5 10years prior to maturity

Types of municipal securitiesGeneral obligation bondsRevenue bondsHybrid bonds


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General obligation bonds

Many general obligation bonds are secured by the issuers unlimitedtaxing 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 haveaccess to taxes beyond property taxes

Double-barreled revenue source includes fees, grants, etc. aswell as taxing power


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Hybrid bond securities

Insured bonds backed by insurance policies writtencommercially in addition to the credit of municipalissuer

Refunded bonds (prerefunded bonds) originallyissued as G.O. or revenue bonds but are now secured byan escrow fund consisting of U.S. government

obligations


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Preferred stockPreferred 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% ofthis income is exempt from federal taxation if the recipient isa qualified corporation.

-Promised returns to holders of preferred are fixed-Preferred holders have priority over common stockholdersfor dividends and liquidation distributions

Cumulative preferred if issuer cannot make a payment, the

dividend accrues until fully paidNon-cumulative preferred if issuer cannot make a payment,owner forgos the paymentPerpetual preferred issues without a maturity date


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Mortgages and mortgage-backedsecuritiesMortgage market is the largest sector of the fixed-incomemarket, 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 somespecified real estate property which obliges the borrowerto make a predetermined series of payments. The lendercan 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 amortgage loanLevel-payment mortgage

Borrower pays interest and principal in equal installmentsover a set period (maturity/term of mortgage) Each monthly

payment consists of1.Interest of 1/12 th of the fixed annual mortgage ratetimes the amount of the outstanding mortgage

balance at the beginning of the previous month2.A repayment of a portion of the principal

The portion of the monthly payment applied to the interest declineseach month, while the payment towards principal increases. Thisdescribes a self-amortizing loan.

Insert Table 22-4


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Mortgage cash flow with servicing feeServicing responsibilities includeCollecting monthly paymentsForwarding proceeds to owners of the loanSending payment notices to mortgagors

Maintaining records of principal balancesMaintaining escrow accounts for property taxes and insuranceInitiating foreclosure proceedings

Cash flow from loan goes to1.servicing fee2.interest payment net of servicing fee3.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 flowuncertain. This occurs when

-Homes are sold

-If market rates fall, there is incentive to pay off the highermortgage 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 acollection or pool of mortgages and sell shares in the pool. This securitization causes payments to be made toshareholders each month.

pass- through coupon rate < pools mortgage rate =servicing feesDue to cash flow uncertainty, the prepayment speed isvariable.Insert Figure 22-1 Insert Figure 22-2


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Types of pass-throughsAgency pass-throughs

-Government National Mortgage Association (Ginnie Mae)-Federally related institution, so is based on full faith and credit ofU.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-throughsSeveral classes of bondholders (tranches) with varying maturitiesPrincipal payments from the underlying are used to retire bonds

Set rules for prioritizing the distribution of principal paymentsamong tranchesPrepayment risk is distributed among the tranches, lowering cashflow uncertainty

Insert Figure 22-3


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Asset-backed securities

Securities backed byCredit card receivablesAuto loansHome equity loansManufactured 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 wefocus on:1.Credit rating of the collateral2.Quality of the seller/servicer3.Cash flow stress and payment structure4.Legal structure


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Quality of the seller/servicerLoan originator or financial institution establishesunderwriting standards, with the rating agenciesevaluating the servicer of the loans. Issues include1.Servicing history

2.Experience3.Originations4.Servicing capabilities

5.Human resources6.Financial condition7.Growth/competition/business environment


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Cash flow stress and payment structure

Cash flow = interest and principal repaymentPayment structure

Payment priorities

Amortization of bond principal repaymentsHow excess cash flow is usedDepends on type of collateral

Rating companies analyze structure to determine if thecollaterals cash flow meets the necessary payments.


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Legal structureBankruptcy-remote special purpose corporation (SPC)

SPC is the issuer of the asset-backed security; underlyingloans are used for collateral for a debt instrument rater thangeneral credit of issuer with the corporate entity retainingsome interest. If the issuer enters bankruptcy, the SPC willavert a bankruptcy court consolidation of the collateral withthe assets of the seller.

SPC is a wholly-owned subsidiary of the seller of the collateral.

Collateral sold to SPCSPC sells to the trustTrust holds collateral for investorsSPC hold the interest retained by seller of collateral


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Cash flow of asset-back securitiesCollateral is either amortizing or non-amortizing

Amortizing assets borrowers payments consists ofscheduled principal and interest payments over life of loan(auto, home equity, residential)

Non-amortizing assets no payment schedule; borrowermakes minimum periodic payment (credit card receivables,some home equity loans)

payment < interest on loan balance shortfall + loan balance payment > interest on loan balance applied to reduction of balance

Prepayments are projected based on changes in interest rates andrefinancing prospects, estimated default rates and the recovery rate.


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Types of asset backed securitiesAuto loanCredit card receivable-backed securitiesHome equity loan-backed securitiesManufactured housing-backed securities


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Auto loanIssued by

Financial subsidiaries of auto manufacturersCommercial banksIndependent finance companies

Cash flowScheduled monthly loan payments (interest and

principal); amortizedPrepayments resulting from

Sales and trade-ins requiring full pay offRepossession and resaleLoss or destruction of vehicleCash payoff to save on interest cost

Refinancing of loan at lower interest cost


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Auto loanPass through structure senior tranche and subordinated trance withan 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 enhancementSenior/subordinated structure: cash reserves or

overcollateralization


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Credit card receivable-backed securitiesIssued by

Banks, retailers, travel and entertainment companiesCash flow

Net interest, principal, finance chargesInterest to security holders paid periodically (fixed or floating)

Lockout (revolving) period principal payments made by credit card borrowersin 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 tocover coupon and fees, default of services, issuer violates pooling and servicingagreements


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Credit card receivable-backed securitiesAmortization structures

Pass-through princiapl from accounts paid to secuityholders on a pro rata basisControlled-amortization scheduled principal amountestablished

Bullet payment amount distributed in a lump sum, with principal paid to a trustee monthly into an interest generatingaccount for an accumulation period

Credit enhancementCash collateral accountCollateral invested account


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M f t d h i b k d iti


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Manufactured housing-backed securitiesIssued 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 VAOther 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, makingrefinancing imprudent. Also, the rate of depreciation is high in the earlieryears making it harder to refinance the loan.

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