Chapter 22 Fixed-Income Securities

Fabozzi: Investment Management Graphics by

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 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

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 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

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

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 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

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 securities

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

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.

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 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

Security for bonds

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

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

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).

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 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

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 securities

General obligation bonds Revenue bonds Hybrid bonds

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

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

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

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.

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

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

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 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

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

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 < pools 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-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

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 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

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.

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 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

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

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.

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

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 < 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 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

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

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

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

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.

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.