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 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.

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.

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.

Bond fundamentalsSome 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

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

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

Quotation convention for Treasury billsQuotes 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

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.

Stripped Treasury securitiesSeveral 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

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

Federal agency securitiesThere are two categories of federal agency securities:

Government-sponsored enterprises securities marketFederally related institutions securities markets

Federally related institutions securitiesWhile 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.

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.

Corporate bondsThe 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

Security for bondsBeyond the general credit standing, real or personal property may be pledged.

Insert Table 22-2

Provisions for paying off bondsCall 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

Call and refund provisionsCall 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).

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

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

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

Putable bonds and floating rate securitiesPutable 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

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

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.

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 securitiesGeneral obligation bonds

Revenue bonds

Hybrid bonds

General obligation bonds

Many general obligation bonds are secured by the issuer’s 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

Revenue bondsThese 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

Hybrid bond securitiesInsured 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

EurobondsA 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.

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% 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

Mortgages and mortgage-backed securitiesMortgage 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

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).

Cash flow characteristics of a mortgage loanLevel-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

Mortgage cash flow with servicing feeServicing 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

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

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 < pool’s mortgage rate = servicing fees •Due to cash flow uncertainty, the prepayment speed is variable.

Insert Figure 22-1

Insert Figure 22-2

Types of pass-throughsAgency 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

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

Stripped mortgage-backed securitiesInstead 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

Asset-backed securitiesSecurities backed by

Credit card receivables

Auto loans

Home equity loans

Manufactured housing loans

These account for about 95% of the total market.

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

Credit quality of the underlying collateralRatings companies look at the following

-Borrower’s ability to pay

-Borrower’s 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

Quality of the seller/servicerLoan 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

Cash flow stress and payment structureCash 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 collateral’s cash flow meets the necessary payments.

Legal structureBankruptcy-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

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

Amortizing assets – borrower’s 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 < 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 and refinancing prospects, estimated default rates and the recovery rate.

Types of asset backed securities

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

Auto loanIssued 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

Auto loanPass 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

Credit card receivable-backed securitiesIssued 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

Credit card receivable-backed securitiesAmortization 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

Home equity loan-backed securitiesHome 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.

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.