Investment Portfolio Sectors and Regulatory Focus

Agencies can be obtained in bullets.
Come in different types of call options:
- One-time calls
- Quarterly calls
- Continuous calls
- Scheduled calls (Canary schedule)
When in charge of the bond portfolio, understand what you're buying related to risk and reward.
If two agencies seem similar but one yields 25 basis points more, it likely has more call options.
If bonds bought at a discount are called earlier than expected due to rate drops, a big yield pop can occur due to faster income accretion.

CDs are issued by banks.
Banks might offer CD specials, often short-term (e.g., 6-12 months).
In today's market, most CD specials are for a short duration, typically 12 months.
Banks prefer liability sensitivity, aiming for liabilities to reprice faster than assets.
CDs can be attractive with positive spreads, especially if banks need liquidity and pay more for deposits.
Treasuries serve as performance benchmarks, with spreads to treasuries assessed for CDs, agencies, etc.
CDs may have call options, particularly offered by big banks recently for longer-term CDs, serving as an interest rate risk protection tool.
If rates fall, issuers can call CDs to avoid high interest payments.
Understand if CDs have options, payment frequency and potential negative spreads.

Muni bonds can be tax-exempt, offering investors the benefit of not paying income taxes on interest income.
Tax exemption is particularly beneficial in high-tax states like Minnesota (up to 10%) and Illinois.
In-state muni bonds may also be state tax-exempt.
Texas has no state income tax, so only federal tax exemption applies.
Muni bonds are issued by US state and local governments to finance infrastructure projects or refinance existing debt.
Issuers include states, counties, cities, school districts, airports, hospitals, and utility authorities.
Municipal issuances often have different maturities, forming a series to ladder debt and cash flow, similar to how banks manage their bond maturities.
Longer maturities typically have call options, generally greater than ten years.
Call options are typically one-time calls, allowing issuers to refinance debt at a lower cost if rates fall.
Municipalities are not always efficient with exercising call options compared to agencies.
Financial advisors (FAs) help determine the least costly way to bring municipal bonds to the market and structure them.

Tax equivalent yield (TEY) is important for comparing muni bond yields to taxable bonds.
Interest on tax-exempt munis is not subject to federal tax.
TEY allows an apples-to-apples comparison by adjusting for the after-tax advantage.
Formula: $TEY = \frac{Nominal Yield}{1 - Marginal Tax Rate}$
Example: If the tax rate is 29.6% (S-corp bank), use that rate in the TEY calculation.
S-corp banks pass tax liability to shareholders, who receive dividends to cover the tax liability.
C-corp banks have a 21% tax rate.
- Example: 3% nominal yield muni bond for a C-corp bank:
- $TEY = \frac{3\%}{1 - 0.21}$
- $TEY = \frac{3\%}{0.79}$
- $TEY = 4.26\%$
The higher the tax rate, the greater the TEY.
C-corp banks, with lower tax rates, typically need to go further out on the yield curve to get a positive spread to treasuries.
High net worth individuals and insurance companies often have a strong appetite for tax-free income from muni bonds.

Community banks typically invest more in tax-free munis.
Taxable munis exist and generally have a higher nominal yield.
C-corps often need to buy munis further out on the yield curve for a positive spread to treasuries, even with the TEY calculation.
Longer-term munis are more likely to have call options.
Not all munis are tax-free; some are taxable.

Loans are originated, pooled, securitized, and sold in the marketplace.
Fixed Income market include: banks, insurance companies, retail investors and the Fed.
Pass-through securities like MBS pass the cashflows to investors.
Without securitization, banks would hold the loans, creating interest rate risk and liquidity issues.
Mortgage loans are sold off to agencies like Fannie Mae and Freddie Mac for securitization.
Agencies charge a fee for guaranteeing timely payment of principal and interest and eliminating credit risk.
Delinquent loans are bought out of the pool by agencies, providing investors with 100 cents on the dollar, which is an involuntary prepayment.
- Example:
  - Average borrower rate: 4.75%
  - G-fee: 50 basis points
  - Servicer fee: 25 basis points
The actual coupon rate is lower than the mortgage holders' rate due to G-fee and servicing fees.

Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) under conservatorship since the financial crisis.
These agencies have an implicit government guarantee.
During the financial crisis, the government stepped in to support Fannie and Freddie.
Fannie and Freddie are 20% risk-based capital.
Ginnie Mae has the explicit guarantee of the US government and is 0% risk-based capital.

Weighted Average Coupon (WAC):
- The average interest rate of the mortgages in the pool, weighted by the size of each mortgage.
Weighted Average Maturity (WAM):
- The average time remaining until the mortgages in the pool mature, weighted by the size of each mortgage.
Average Life:
- The expected life of the mortgage-backed security, taking into account prepayments.
Prepayments:
- Payments made on the mortgages in the pool before their scheduled due date.
Refinancing, selling the home, and defaults are examples of prepayments.

Refinancing is the most common form of prepayment.
Understanding how a mortgage-backed security may or may not refinance is very important.
- Interest rates influence refinancing - most common type of prepayment.
Low or high coupon rates influence likelihood of refinancing.
Newly issued 30-year mortgages at 7% - attractive yield, high-risk if rates drop.
3% coupon seasoned bond purchased at a discount - lower yield, preferred is rates fall.

Coupon - stability comes from lower rates.
Structure and prepayment stability and cash flow stability are often favored over yield.

Geographic concentration can be geographically specific - geographical distribution dependent.
Geographical concentration such geography influence prepayment.
New York has refinance tax which slow prepayment.
Geographic risk with states along the coast.

There are constant payments of principal and interest in the absence of any prepayments.
In the presence of prepayments there is the existence of a curve.
Mortgage-backed securities are called cash flow bonds because of the monthly principal and interest payments.
Prepayments are super important in mortgage backed security investing.
Too much and too little are bad with regards to prepayments.
The attribute dictates whether the mortgage will prepay.
They are model an analytical which are not of perfect science.
It's not always a perfect science.

A blended portfolio has the effects of the effects of increasing revenue and mitigating risk - improving portfolio over the long term.