Fixed Income part 2 (last quarter of material)

governments issue debt either for

fiscal policy or budget needs

emerging market governments do have

credit risk

sovereign immunity

limitations on forcing a government to declare bankruptcy or liquidate

government fiscal flexibility

discipline over time and different economic conditions

government monetary effectiveness

level of independence of central bank and record of growth and price stability

economic flexibility

diversification and integration, size of informal economy, growth potential

external status of a country includes

international trade, capital, foreign exchange policy, ability to service debt, reserve currency status (is your currency fully convertible and held by others?

frontier/emerging market countries often have

foreign exchange restriction, capital controls, lack of convertibility of currency

fiscal strength is measured by what measures?

fiscal debt to GDP, debt to revenue, interest to revenue, interest to GDP

growth is measured by what measures?

real gdp and real gdp growth, standard deviation of real gdp, per capita GDP

external stability of a country is

willingness of foreigners to hold assets in currency

what are measures pf external stability?

currency reserves to GDP, currency reserves to external debt, long-term debt to GDP, short-term debt to GDP

for emerging markets, the majority of foreign reserves are

commodity exports, commodity prices determine sovereign credit quality

examples of non-sovereign government entities are

government agencies, government sector banks, development banks, supranational agencies

general obligation bonds are generally

unsecured, less credit risk because supported by local taxes

revenue bonds are

higher credit risk, dependent on project cash flows

the viability of a project underlying a revenue bond is determined by what ratio?

debt service coverage ratio = revenue/interest + principal payments

what factors are relevant to credit for nonfinancial corporations?

corporate governance (use of proceeds, taxes and accounting), business model, industry and competition, business risk (deviations from expectations)

high yield debt is generally

secured

a top-down approach to analyzing nonfinancial corporate credit risk

company growth vs GDP growth, economic conditions, market share, scenario analysis

bottom-up approach to analyzing nonfinancial corporate credit risk

issuer’s liquidity, leverage, profitability, revenue growth, operating profit, debt service or interest coverage ratio

a higher ebit margin generally means a

higher credit rating

the highest seniority debt is

first lien or mortgage (specific property pledged)

if secured debt is not fully backed by assets, it becomes

equal with senior unsecured debt

anything lower than senior unsecured debt has

little to no recovery in event of default

after a default occurs, debt continues to trade at and until

rates close to expected recovery rate, until resolution

recovery rates vary by

industry and economic conditions

the priority of claims to debt is a legal standard, but parties can

agree differently to speed up the process and minimize legal fees

an issuer’s rating is generally the same as its

senior unsecured debt

different issues from the same issuer can have different ratings based on

different loss given default based on priority ranking

the process of adjusting credit ratings is called

notching, each rating is a notch

the senior secured debt is generally rated

1 grade above senior unsecured

the junior debt is generally rated

1 grade below the senior unsecured

if companies are structured with a parent and subsidiaries, debt claims are first filled

at the operating company level, then the parent/holding company

how does fixed-income securitization work?

banks pool loans, sell to SPEs who issue bonds and give proceeds to bank, who give interest to bondholders from loan payments

covered bonds

not securitized, assets stay with bank but are segregated to be collateral, defaulted or prepaid loans are replaced by asset monitor, one bond class

pass-through loans

given to SPE, which issues securities, loan payments are passed through to bondholders

structural enhancements for pass-through loans include

credit and time tranching

the lowest credit tranche is called the

equity tranche, first loss piece

RMBS

residential mortgage backed security

CMBS

commercial mortgage backed security

asset-backed securities include

CDO, CLO, CBO, CDO squared

benefits of securitization for issuers

sell assets to free up cash for more loans, get loan and origination fees, lower capital required

benefits of securitization for investors

access to new pool of returns, tailored interest rate risk with time tranche or credit risk with credit tranche

benefits of securitization for economies and financial markets

increase liquidity, market efficiency, sources of capital to finance assets

risk of securitization

cash flow timing differs based on interest rates, assumes the credit risk of loans backing the bonds (less important for mortgages because of property collateral)

extension risk

if interest rates go up, payment speed goes down for loans

contraction/prepayment risk

if interest rates go down, payment speed goes up

the seller or originator of asset-backed securities is

the bank

who services loans underlying asset-backed securities?

the originator

purchase agreement

between originator and SPE, includes warranties to SPE about collateral

prospectus

between SPE and investors in securities, describes securitization structure, payments, credit enhancements

trustee

a disinterested party in a securitization agreement, holds assets and funds due to bondholders until payment period

what does it mean that the SPE is bankruptcy remote?

they have a lower cost of debt because they own the loans, will be unaffected if the bank files for bankruptcy

bond investor’s credit risk in securitized assets is limited to

the collateral only, not the originator

bond investors have claim to what for covered bonds?

cover pool and issuer’s assets

covered bonds are always

overcollateralized

hard bullet covered bonds

payments increase if default, issuer sells loans to full redemption

soft bullet covered bonds

lower credit risk, payment delay if default, final redemption date extended up to a year

conditional pass through bonds

convert to pass throughs after maturity

covered bonds generally have

lower credit risk and lower yields than securitized assets

spe credit enhancements for asset backed securities

overcollateralization, excess spread (average collateral coupon - average bond coupon), tranching (waterfall approach), bank or insurance company guarantees or cash collateral accounts

the waterfall approach for credit tranching refers to

principal only, interest flows to all

asset-backed securities can be

amortizing or not

revolving period

common in credit card loans, principal reinvested for some time, interest-only payments, then amortization by tranches

rapid amortization provision

if defaults are over a threshold during revolving period, principal repayment starts early

solar ABS

backed by solar loans/leases or green bonds, if existing mortgage on property then junior loans, can have prefunding period (can add more loans to pool after bonds issued)

CDO

collateralized debt obligation, backed by pool of obligations

CBO is backed by

commercial or emerging market bonds

CLO is backed by

leveraged loans

a synthetic CDO is a

credit default swap on an existing CDO, cash flows from selling CDS (insurance against default)

a standard CDO is unique in that it is

tranched but collateral pool is variable (can be bought or sold by collateral manager)

a collateral manager in a CDO

looks for debt, sells tranched bonds against that debt, adds sale proceeds to returns of investor

CLO general characteristics

mostly senior secured loans (average B credit rating), diversified, overcollateralized, 100-225 issuers, actively managed by collateral manager

what are the CLO types?

cash flow CLO, market value CLO (return based on collateral’s value), synthetic (collateral from credit derivatives)

if a CLO fails its performance tests,

principal paid to senior class until correction, called deleveraging

a collateral portfolio for a CDO is not final until

after transaction closes (8 to 10 years)

what are the lifecycle parts of a CDO?

warehouse period, 6 to 12 months, someone acquires loans, ramp-up period, 3 to 5 months, excess funds from CDO used to get more loans, reinvestment period, up to 5 years, collateral manager trades, then amortization period

when does the amortization period begin for a CLO?

if overcollateralizaion test fails for one of the tranches, principal flows back up from that tranche until all senior tranches filled

in a CLO, what tranche earns the highest returns?

senior or mezzanine tranche

the asset pool for a CLO is owned by, financed by

the equity investor, financed by debt investors

the most important tranche is the

equity tranche because first loss

contraction risk for MBS means that

more cash flows occur when reinvesting rate is low, negative convexity

extension risk for MBS means that

less cash flows occur when reinvestment rates are high, increases Macaulay duration

time tranching

within each credit tranche, create time tranches where A gets principal first, then B and so on

A and B tranches avoid what risk?

extension risk

C and D tranches avoid what risk?

contraction risk

the loan to value ratio for a mortgage is originally based on

price minus deposit, decreases over time as loan reduced by principal payments and value increased by rising house prices

DTI ratio

debt to income, monthly mortgage payment divided by monthly pre-tax income

a prime or conforming mortgage

meets LTV and DTI standards, low DTI, high credit, first lien

an agency MBS is a

residential MBS guaranteed by federal agency or GSE, conforming mortgages only

non-agency MBS

no government guarantee, privately issued, includes nonconforming mortgages

mortgage contingency features

prepayment options (with potential penalties), recourse or nonrecourse in event of default

recourse mortgage

lender can personally claim against borrower if LTV over 1 (underwater)

nonrecourse mortgage

standard in US, lender can only claim against property

strategic default

if nonrecourse mortgage, borrower may decide to abandon mortgage if underwater (but affects their credit)

the profit of an SPE is based on the difference between

weighted average coupon rate of loans minus pass-through rate of securities, which includes service fees

weighted average coupon rate is based on

market values

weighted average maturity is measured in

months