cmta advanced treasury workshop floating rate notes, fixed to float securities, step down bonds and...
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CMTAAdvanced Treasury Workshop
Floating Rate Notes, Fixed to Float Securities, Step Down Bonds and Convexity
Presented by:Tony Garcia, CFAVice President
Pomona, CA
January 31, 2012
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If you can’t explain it to a six year old, you don’t understand
it yourself.
-Albert Einstein
On the Agenda
Floating Rate Securities A security where the coupon floats relative to an index
Fixed to Float Securities A security that has a fixed coupon for a period and then
converts to a floating rate security
Step Down Bonds A callable security where the coupon declines
Negative Convexity The bane of callable buyers
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Floating Rate Securities
Floating Rate Securities
Coupon Floats Relative to Index (Benchmark or Reference rate)
Coupon Rate = reference rate (index) +/- quoted margin
Indexes Fed Funds – Daily Reset Libor – O/N, 1 Month, 3 Month, 6 Month, 12 Month CMT – Spread to Constant Maturity Treasury with regular resets Commercial Paper Prime Rate Treasury Bill – 1 Month, 3 Month, 6 Month TIPS – Inflation Indexed
Inverse Floaters – Where the coupon moves in the opposite direction to the reference rate *You cannot buy these*
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Floating Rate Securities
Issuers Treasury – TIPS Agencies – Debentures and Asset Backed Municipalities Corporations
Discount Margin Effective spread to index
Caps and Floor Cap – The limit to which a coupon can float Floor – Minimum possible coupon Collar – When security has both a cap and a floor
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Components Of Pricing
Spread to Index determines coupon
Reset Frequency
Maturity
Change in Basis
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Discount Margin
Discount margin is the inferred change in spread to Index
Price changes to reflect change in market
Price change = PV of change in DM As with YTM
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Basis Risk
Change in DM to reflect adjustments in market If credit quality improves DM should decline If credit quality deteriorates DM will widen If spreads narrow DM will decline May also change due to change absolute level of interest rates
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ING BANK Step Up FRN
Source: Bloomberg
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ING BANK Step Up FRN
Source: Bloomberg
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ING BANK Step Up FRN
Source: Bloomberg
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Value To A Portfolio
Lower Duration Reset frequency lowers effective duration
Lower Price volatility
Yield will move in direction of underlying index
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Berkshire FRN 2/11/13 Reset 3 MO Libor +43
Source: Bloomberg
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Berkshire FRN 2/11/13 Reset 3 MO Libor +43
Source: Bloomberg
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Berkshire FRN and Treasury 2.75% 2/13
BRK FRN 2/13 TSY 2.75 2/13
DATE PRICE YIELD PRICE YIELD
2/11/10 100.000 DM + 43 104.012 1.40
1/11/11 100.905 DM + 13 106.419 0.62
CHANGE +.905 DM -30 +2.407 -0.78
Note: Settlement date held static at 2/11/10 to avoid amortization effect
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Fixed to float securities
Fixed to Floating Rate Securities
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Securities begin with a Fixed Coupon rate for specified period then will switch to a Floating Rate Coupon
May be bulleted or callable
Issued by Agencies and Corporations
Can provide protection against rising rates Basis shift out of a low volatility environment can be a concern
Agency Fixed to Float
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Source: Bloomberg
Agency Fixed to Float – Coupons
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Source: Bloomberg
Corporate Fixed to Float
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Source: Bloomberg
Agency Fixed to Float – Coupons
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Source: Bloomberg
Step down bonds
Step Down Callable
Security structure where coupon steps down if bond not called
Likelihood of call is very small
Short term cash flow is the focus
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Source: Bloomberg
Step Down Callable
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Step Down Callable – YTC Schedule
Source: Bloomberg
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5 Year Treasury Yield
Source: Bloomberg
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One Time Callable
Source: Bloomberg
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Agency Bullet Yield Curve
Source: Bloomberg
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Step Down Callable OAS Analysis
Source: Bloomberg
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Callable Agency OAS Analysis
Source: Bloomberg
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Step Down Callable – Comparison
YTM Option value
Step Down 2.08 0.59
Callable 2.40 1.82
Treasury 2.07
Agency Bullet 2.25
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Step Down Callable – Cash Flows
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
One time payments Step down payments Bullet Payments
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Convexity
Convexity/Negative Convexity
Convexity A Measure of how curved the price-yield curve is The second derivative of the price-yield function
Low coupon and long maturity bonds tend to have high convexities
High coupon and short maturity bonds tend to have low convexities
Negative Convexity
Where the rate of change of the price of a bond slows as rates fall Generally due to embedded option(s)
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Price / Yield Function
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PRICE
YIELD
Duration
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PRICE
YIELD
Convexity
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PRICE
YIELD
{
}
Convexity Changes
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PRICE
YIELD
Negative Convexity
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PRICE
YIELD
Negative Convexity
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PRICE
YIELD
12 Month Horizon Return
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Pricing Date: 01/16/2013 Type: Spot Curve
Currency: USD Horizon Months: 12
Reinvestment Rate: .104
Issuer Coupon Maturity YTW Eff Dur ConvFieldName -300 -200 -100 0 100 200 300
BULLET 0.750 01/12/2018 0.850 4.886 0.133
Total Return 14.254 9.830 5.599 1.555 -2.313 -6.013 -9.553
Ending Price 112.950 108.547 104.337 100.311 96.461 92.778 89.253
Ending Avg Life 4.000 4.000 4.000 4.000 4.000 4.000 4.000
Ending Eff Dur 3.989 3.967 3.946 3.925 3.905 3.884 3.864
Ending Conv 0.090 0.089 0.088 0.087 0.087 0.086 0.085
STEP UP 0.700 01/30/2018 0.700 2.188 -1.406
Total Return 0.350 0.350 0.525 0.547 -1.465 -4.880 -8.463
Ending Price 100.000 100.000 100.000 100.000 97.861 94.445 90.860
Ending Avg Life 0.000 0.000 0.000 0.000 3.000 3.500 4.000
Ending Eff Dur 0.000 0.000 0.000 0.000 2.487 3.401 3.870
Ending Conv 0.000 0.000 0.000 0.000 -0.307 0.217 0.061
CALLABLE 1.000 01/11/2018 1.000 2.504 -1.647
Total Return 0.486 0.486 0.486 0.540 -1.753 -5.442 -8.975
Ending Price 100.000 100.000 100.000 100.000 97.245 93.554 90.019
Ending Avg Life 0.000 0.000 0.000 0.000 4.000 4.000 4.000
Ending Eff Dur 0.000 0.000 0.000 0.000 3.315 3.861 3.842
Ending Conv 0.000 0.000 0.000 0.000 -0.480 0.083 0.084
FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13Coupons: 0.70 to 1/160.875 to 7/161.0 to 1/172.0 to 7/173.0 to 1/18
FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13
FHLMC 0.75% 1/12/18
Source: Bloomberg and Bond Edge
12 Month Horizon Return
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Pricing Date: 01/16/2013 Type: Spot Curve
Currency: USD Horizon Months: 12
Reinvestment Rate: .104
Issuer Coupon Maturity YTW Eff Dur ConvFieldName -300 -200 -100 0 100 200 300
BULLET 0.750 01/12/2018 0.850 4.886 0.133
Total Return 14.254 9.830 5.599 1.555 -2.313 -6.013 -9.553
Ending Price 112.950 108.547 104.337 100.311 96.461 92.778 89.253
Ending Avg Life 4.000 4.000 4.000 4.000 4.000 4.000 4.000
Ending Eff Dur 3.989 3.967 3.946 3.925 3.905 3.884 3.864
Ending Conv 0.090 0.089 0.088 0.087 0.087 0.086 0.085
STEP UP 0.700 01/30/2018 0.700 2.188 -1.406
Total Return 0.350 0.350 0.525 0.547 -1.465 -4.880 -8.463
Ending Price 100.000 100.000 100.000 100.000 97.861 94.445 90.860
Ending Avg Life 0.000 0.000 0.000 0.000 3.000 3.500 4.000
Ending Eff Dur 0.000 0.000 0.000 0.000 2.487 3.401 3.870
Ending Conv 0.000 0.000 0.000 0.000 -0.307 0.217 0.061
CALLABLE 1.000 01/11/2018 1.000 2.504 -1.647
Total Return 0.486 0.486 0.486 0.540 -1.753 -5.442 -8.975
Ending Price 100.000 100.000 100.000 100.000 97.245 93.554 90.019
Ending Avg Life 0.000 0.000 0.000 0.000 4.000 4.000 4.000
Ending Eff Dur 0.000 0.000 0.000 0.000 3.315 3.861 3.842
Ending Conv 0.000 0.000 0.000 0.000 -0.480 0.083 0.084
FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13Coupons: 0.70 to 1/160.875 to 7/161.0 to 1/172.0 to 7/173.0 to 1/18
FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13
FHLMC 0.75% 1/12/18
Source: Bloomberg and Bond Edge
12 Month Horizon Return
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Pricing Date: 01/16/2013 Type: Spot Curve
Currency: USD Horizon Months: 12
Reinvestment Rate: .104
Issuer Coupon Maturity YTW Eff Dur ConvFieldName -300 -200 -100 0 100 200 300
BULLET 0.750 01/12/2018 0.850 4.886 0.133
Total Return 14.254 9.830 5.599 1.555 -2.313 -6.013 -9.553
Ending Price 112.950 108.547 104.337 100.311 96.461 92.778 89.253
Ending Avg Life 4.000 4.000 4.000 4.000 4.000 4.000 4.000
Ending Eff Dur 3.989 3.967 3.946 3.925 3.905 3.884 3.864
Ending Conv 0.090 0.089 0.088 0.087 0.087 0.086 0.085
STEP UP 0.700 01/30/2018 0.700 2.188 -1.406
Total Return 0.350 0.350 0.525 0.547 -1.465 -4.880 -8.463
Ending Price 100.000 100.000 100.000 100.000 97.861 94.445 90.860
Ending Avg Life 0.000 0.000 0.000 0.000 3.000 3.500 4.000
Ending Eff Dur 0.000 0.000 0.000 0.000 2.487 3.401 3.870
Ending Conv 0.000 0.000 0.000 0.000 -0.307 0.217 0.061
CALLABLE 1.000 01/11/2018 1.000 2.504 -1.647
Total Return 0.486 0.486 0.486 0.540 -1.753 -5.442 -8.975
Ending Price 100.000 100.000 100.000 100.000 97.245 93.554 90.019
Ending Avg Life 0.000 0.000 0.000 0.000 4.000 4.000 4.000
Ending Eff Dur 0.000 0.000 0.000 0.000 3.315 3.861 3.842
Ending Conv 0.000 0.000 0.000 0.000 -0.480 0.083 0.084
FNMA 0.70% 1/30/18 QUARERLY CALLS 7/30/13Coupons: 0.70 to 1/160.875 to 7/161.0 to 1/172.0 to 7/173.0 to 1/18
FHLB 1.0% 1/11/18 QUARTERLY CALLS 7/11/13
FHLMC 0.75% 1/12/18
Source: Bloomberg and Bond Edge
Portfolio Comparison – Bullets vs Callables
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Security detail
Portfolio Bullets Portfolio CallablesPar $70,000,000 Par $70,000,000
Market Value $71,085,000 Market Value $70,225,000
Average Life 1.328 Average Life 1.246
YTM 0.517 YTM 0.918
Modified Duration 1.31 Modified Duration 3.32
Effective Duration 1.16 Effective Duration 1.30
Convexity 0.10 Convexity -0.77
Porfolio distribution
Source: Bloomberg and Bond Edge
Security Shock Testing
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0.55 0.550.55 0.540.54 0.530.54 0.450.54 0.380.53 0.370.53 0.37
0.08 0.070.08 0.060.06 0.060.06 0.061.13 0.941.67 1.611.67 1.63 $67,998 -3.17%
graphical performace
-0.08%
Aged scenario200 -1.72 0.01 $69,020 -1.72%300 -3.17 0.03
(12 month horizon)
0 0.39 0.00 $70,499 0.39%100 -0.08 -0.14 $70,171
-200 0.30 0.00 $70,432 0.29%-100 0.24 0.00 $70,395 0.24%
-300 0.36 0.00 $70,477 0.36%
$70,994 -0.13%
profile of forward
performance Callables
Yield Change projected total return
ave life effective duration
convexity market value
% change in market value
0.27%
Aged scenario200 0.07 0.00 $71,133 0.07%300 -0.13 0.00
(12 month horizon)
0 0.48 0.06 $71,427 0.48%100 0.27 0.01 $71,276
-200 1.45 0.01 $72,118 1.45%-100 0.92 0.02 $71,737 0.92%
market value
% change in market value
-300 2.00 0.01 $72,508 2.00%profile of forward
performance Bullets
Yield Change projected total return
ave life effective duration
convexity
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
-300 -200 -100 0 100 200 300
Eff DurationBullets Callables
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
-300 -200 -100 0 100 200 300
% volatility of mkt val
Bullets Callables
Source: Bloomberg and Bond Edge
Security Shock Testing
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0.55 0.550.55 0.540.54 0.530.54 0.450.54 0.380.53 0.370.53 0.37
0.08 0.070.08 0.060.06 0.060.06 0.061.13 0.941.67 1.611.67 1.63 $67,998 -3.17%
graphical performace
-0.08%
Aged scenario200 -1.72 0.01 $69,020 -1.72%300 -3.17 0.03
(12 month horizon)
0 0.39 0.00 $70,499 0.39%100 -0.08 -0.14 $70,171
-200 0.30 0.00 $70,432 0.29%-100 0.24 0.00 $70,395 0.24%
-300 0.36 0.00 $70,477 0.36%
$70,994 -0.13%
profile of forward
performance Callables
Yield Change projected total return
ave life effective duration
convexity market value
% change in market value
0.27%
Aged scenario200 0.07 0.00 $71,133 0.07%300 -0.13 0.00
(12 month horizon)
0 0.48 0.06 $71,427 0.48%100 0.27 0.01 $71,276
-200 1.45 0.01 $72,118 1.45%-100 0.92 0.02 $71,737 0.92%
market value
% change in market value
-300 2.00 0.01 $72,508 2.00%profile of forward
performance Bullets
Yield Change projected total return
ave life effective duration
convexity
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
-300 -200 -100 0 100 200 300
Eff DurationBullets Callables
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
-300 -200 -100 0 100 200 300
% volatility of mkt val
Bullets Callables
Source: Bloomberg and Bond Edge
Security Shock Testing
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0.55 0.550.55 0.540.54 0.530.54 0.450.54 0.380.53 0.370.53 0.37
0.08 0.070.08 0.060.06 0.060.06 0.061.13 0.941.67 1.611.67 1.63 $67,998 -3.17%
graphical performace
-0.08%
Aged scenario200 -1.72 0.01 $69,020 -1.72%300 -3.17 0.03
(12 month horizon)
0 0.39 0.00 $70,499 0.39%100 -0.08 -0.14 $70,171
-200 0.30 0.00 $70,432 0.29%-100 0.24 0.00 $70,395 0.24%
-300 0.36 0.00 $70,477 0.36%
$70,994 -0.13%
profile of forward
performance Callables
Yield Change projected total return
ave life effective duration
convexity market value
% change in market value
0.27%
Aged scenario200 0.07 0.00 $71,133 0.07%300 -0.13 0.00
(12 month horizon)
0 0.48 0.06 $71,427 0.48%100 0.27 0.01 $71,276
-200 1.45 0.01 $72,118 1.45%-100 0.92 0.02 $71,737 0.92%
market value
% change in market value
-300 2.00 0.01 $72,508 2.00%profile of forward
performance Bullets
Yield Change projected total return
ave life effective duration
convexity
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
-300 -200 -100 0 100 200 300
Eff DurationBullets Callables
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
-300 -200 -100 0 100 200 300
% volatility of mkt val
Bullets Callables
Source: Bloomberg and Bond Edge
Dynamic Cash Flow Shock Testing
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Bullets Callables Callables Bullets Callables1.05 2.63 1.31 1.29 0.49
$34,985 $34,371 $60,345 $34,959 $60,331
flat fallingBullets
projected duration 1.1612 month reinvestment risk $34,965
rising rates: +100 b.p.
flat rates: 0 b.p.
falling rates: -100 b.p.
analysis of cash flow
rate scenario rising
3498519538 17214
0 0
34371
525215188 8119
8042
$0
$25,000
$50,000
$75,000
$100,000
1 YR 2 YR 3 YR 4 YR 5 YR
Bullets Callables
34965
19468 17160
0 0
60345
7035 3008 0 0
$0
$25,000
$50,000
$75,000
$100,000
1 YR 2 YR 3 YR 4 YR 5 YR
Bullets Callables
34959
19460 17154
0 0
60331
7035 3008 00
$0
$25,000
$50,000
$75,000
$100,000
1 YR 2 YR 3 YR 4 YR 5 YR
Bullets Callables
Source: Bloomberg and Bond Edge
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Contact Information
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Tony Garcia, CFAVice President
MAC A0716-07T400 Capitol Mall, 7th FloorSacramento, CA 95814
Phone: (888) 267-9113 FAX: (916) 442-2750 Email: [email protected]
The opinions expressed in this presentation are general in nature and not intended to provide specific advice or recommendations. Contact your investment representative, attorney, accountant or tax advisor with regard to your specific situation. The opinions of the author do not necessarily reflect those of Wells Fargo Institutional Securities, LLC or any other Wells Fargo entity.
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