If a 5-year bullet bond issued by CitiGroup traded at a yield of 3.9825% what could we say about that? Is that cheap? What do we need to know first?
What is the risk-free rate of a 5year bond? (5yr UST = 3.470).
So – now what can we say?
Many Fixed Income Products are quoted as a spread in yield above the treasury curve.
e.g. A Corporate bond with a spread of 220bps with a maturity of 11/15/08 would have a yield of what?
5-year yield = 3.4700
3.4700+2.20 = 5.6700%
What is the problem w/ the UST Curve?
Interest Rate (Vanilla) Swaps Bank Customer
Bank Pays the Customer a fixed rate (4.895%)
Bank receives from the Customer a floating rate (3mo Libor)
Why is this exactly the same as the bank selling a bond to the customer?
What if I found the rate at which the bank is indifferent to paying fixed or receiving fixed?
What if I found that rate for multiple maturities?
Interest Rate Swaps
(Refer to Professor Palacios’ Lecture Note number 13 for an in-depth discussion).
Source: GS Nov 10 th 3pm Closes
Interest Rate Swaps (cont.)
Swaps are also very liquid – and an effective form of hedging spread product. Why?
Many Spread Products can be quoted in spread above the USD Swap curve in addition to the US Treasury Curve.
In fact, our CitiGroup 5 year bond example really was quoted as Swaps + 8bps
Should Corporate Debt ever trade tighter than Swaps+0? Tighter than Treasuries+0?
Introduction to Asset Securitization
“What is a Mortgage”
Mortgages as a Fixed Income investment
What else can you securitize?
Tradable Fixed Income Supply (2002 Information)
What is a Mortgage?
Simply: Mortgages are the loan that homeowners borrow from banks to purchase their homes
The homeowner pays a monthly amount that consists of both Principal and Interest.
The borrower pledges the underlying land as collateral for the loan
If the borrower fails to make re-payment, the mortgage gives the lender the right of foreclosure on the loan and therefore can seize the property
This can be viewed as an investment by the banks in the mortgage market – they are purchasing an asset that pays a monthly amount of Principal and Interest (P&I)
The banks often sell these assets to other investors to raise capital
Home Owner Lending Institution Mortgage Funds =
What are Mortgage Backed “Pass-Through” Securities?
A number of similar mortgages (underlying collateral, design, rates and maturities) are combined into a single group
Mortgage documents associated with this group are delivered to a custodian and are assigned an identification (pool) number
A Mortgage Backed Security (MBS) is issued with a face amount equal to the cumulative outstanding principal balance of the mortgages (original balance)
The mortgages that have been pooled together serve as the collateral for the security
Most MBS are guaranteed and/or issued by a U.S. Government Agency (FNMA, Freddie Mac or GNMA)
+ + = Securitized Mortgage Pool or Pass-throughs
Agency Conforming MBS Origination Process Residential loans originated within the conforming Agency guidelines are guaranteed by an Agency, sold to the Street then either traded in pass-through form or used to structure a CMO…
Non-Conforming MBS Origination Process Loans that do not conform to Agency standards are sold in “whole loan” form or structured into a senior/subordinate private label CMO…
Who Buys Mortgages?
Mortgage Security Holdings by Investor Type in 2002…
Amounts in $US billions Banks and Agencies drive investment flows in the mortgage market, holding nearly 60% of all MBS
Overview of the U.S. Mortgage Securities Market
Largest Sector of the U.S. Debt Market:
Aggregate current principal amount outstanding mortgage loans is over $4.9 trillion as compared to about $3.3 trillion of government securities and $4.4 trillion of Corporate bonds.
Mortgage backed securities (MBS) are an integral part of any broad portfolio exposure to the U.S. Government securities. The U.S. investment grade corporate debt market is less than 1.5 trillion in size.
MBS can enhance portfolio performance significantly
Major mortgages indices have outperformed comparable duration U.S. Treasuries by an average of more than 140 bp over the past 10 years.
The U.S. mortgage market consists of a wide array of securities to suit most investor needs. A full range of credit qualities, durations, risk profiles and yields exist in this market.
High Credit Quality
Most of the MBS market is issued by U.S. Government agencies which have an implied AAA rating: GNMA issues carry full faith and credit of the U.S. Government, Fannie Mae and Freddie Mac have the implicit backing of the U.S. Government.
Non-agency mortgage securities mostly consist of AA or better rated bonds. Lower rated securities (down to single-B) are also available.
Why Invest in Mortgages?
Yield and no credit concerns
What’s the catch?
You are purchasing a product with an imbedded call option
Duration is very hard to determine.
Variability in Average Life can be substantial
You are purchasing an amortizing product
Reinvestment of Principal monthly can reduce yield.
"Duration" Deserves Special Focus in Mortgages...
Modified duration, Macaulay duration, cashflow duration: all measure a mortgage's price sensitivity to rate movements, assuming the cashflows are held constant.
Usually not a good assumption in mortgage product owing to prepayments
Durations often quoted as a percentage of modified duration
Option-adjusted duration (OAD), model duration: measure price sensitivity for small rate movements, assuming constant OAS
Doesn't account for how securities actually trade
Reliant on prepayment model
Empirical duration, EOAD: regression of performance vs rates
can be price or OAS vs rates
adjusted for volatility, slope of the curve
Any payments by borrower made in excess of scheduled principal payments are called prepayments
The option is defined by the borrower's right to prepay all or part of the mortgage at any given time
The uncertainty for the mortgage holder which results is termed prepayment risk
Prepayment may occur for one of several reasons
sale of property
Motivations beyond rational economic considerations play an important roll in assessing prepayment risk
Risk for Mortgage Holder
Interest rate risk (re-investment risk): Should mortgage be fixed-rate, market risk arises as a result of prepayment if rates fall and coupons are above market
Liquidity risk: Should mortgage portfolio be securitized for debt issuance, prepayment implies the need to raise new financing
Duration and Convexity
Convexity is the change in Duration as yields change