Fixed Income Securities - Notes

Fundamental Concepts of Fixed Income Securities

  • Fixed Income Asset Classes and Securities Valuation Techniques
  • Portfolio Techniques, Asset-Liability Management and Derivatives
    • Asset Backed Securities and Structured Products (CMBS, CDO, Credit Cards)
    • Bond Portfolio Strategies
    • Asset-Liability Management: Banks, Pensions and Insurance

Introduction to Asset Backed Securities

  • Securitization: Moving assets from the owner to a special legal entity.
  • Asset-Backed Securities: Securities collateralized by a pool of assets (e.g., auto loans, credit card receivables) and sold to investors.

Securitized Assets

  • Assets used to create asset-backed bonds include:
    • Residential mortgages
    • Home Equity Loans
    • Commercial mortgage loans
    • Automobile loans
    • Student loans
    • Bank loans
    • Credit card debt

Benefits of Asset Securitization

  • Allows investors direct exposure to portfolios of mortgages or receivables without bank intermediaries.
  • Increases funds available for banks to lend and boosts fee income.
  • Creates tradable securities with better liquidity than original loans.
  • Enables innovation in investment products.

Asset Securitization Process

  • Originator (Seller of the Collateral): Originally owns assets, sells them to the SPV
  • Special Purpose Vehicle (SPV): Creates and sells securities backed by the assets to investors.
  • Third Parties: Independent accountants, lawyers, trustees, underwriters, rating agencies, guarantors, and servicers.

Non-agency Residential Mortgage-Backed Securities

  • Non-agency RMBS share features with agency CMOs but require two mechanisms:
    • Cash flows distributed by rules like waterfall, dictating allocation of interest and principal to tranches by priority.
    • Rules for allocating realized losses, with subordinated bond classes having lower payment priority than senior classes.

Commercial Mortgage-Backed Securities (CMBS)

  • CMBS are backed by pools of commercial mortgage loans on income-producing properties.
  • Commercial mortgage loans are non-recourse; lenders can only look to the property for repayment.

CMBS Historical Context

  • Pre-mid-1990s: U.S. real estate was a private market dominated by banks, life insurance companies, and pension funds.
  • Ownership was regionally focused, concentrated in families and private partnerships.
  • Real estate recession of late 1980s/early 1990s:
    • Commercial real estate prices fell significantly.
    • Delinquency rates soared.
    • Traditional lenders exited the market.
    • Regulators and rating agencies viewed commercial mortgage holdings negatively.
  • Innovation opportunities and a shift from private to public ownership emerged due to low real estate values and lender exits.
  • REITs began buying undervalued real estate, funded through public stock and bond offerings, providing diversified real estate investments.
  • Investment banks applied securitization structures from RMBS to commercial mortgages.
  • In the mid- to late-1980s, issuers securitized loans on single properties into CMBS.

CMBS Structures and Analysis

  • CMBS have simpler structures than residential mortgage counterparts.
  • Each tranche has its credit rating, average life, and characteristics.
  • Bonds are usually sequential pay: amortization, prepayments, and default recoveries go to the most senior class. The lowest-rated remaining class absorbs losses.
  • Commercial mortgages usually have prepayment penalties, making credit analysis more important than prepayment analysis.
  • CMBS investment requires analysis at property, loan, and bond levels.

CMBS Typical Structure

  • Properties generate mortgages which are placed into an asset pool.
  • The real estate mortgage investment conduit (REMIC) divides the pool into liabilities such as AAA, AA, and NR (Not Rated) tranches.

CMBS: Non-Recourse Loans

  • Lenders can only look to the income-producing property for interest and principal repayment.
  • Two measures of credit performance:
    • Loan-to-value ratio (LTV)
    • Debt-to-service coverage ratio (DSCR) = Net operating income (NOI) / Debt service

CMBS: Net Operating Income (NOI)

  • Equals total revenue from property minus reasonably necessary operating expenses.
  • Revenue sources: rent, parking, service fees.
  • Operating expenses: insurance, property management fees, utilities, property taxes, repairs, janitorial fees.
  • NOI is a before-tax figure, excluding loan payments, capital expenditures, depreciation, and amortization.

CMBS: Cap Rate

  • Calculated as NOI divided by asset value.
  • Assesses the yield of a property over one year.
  • Example: Property worth $14 million generating $600,000 NOI has a cap rate of 4.3\%. It means \approx 4.3\%$ annual operating cash flow given price paid for the property

Non-Mortgage Asset-Backed Securities

  • Collateral can be:
    • Amortizing assets (e.g., auto loans, personal and commercial loans). Principal from repayments and prepayments is distributed based on a waterfall structure.
    • Non-amortizing assets (e.g., credit card receivables). Prepayments by borrowers are not applicable. These have lockout periods where principal repayments are reinvested.

Auto Loan Backed Securities

  • Cash flows consist of monthly loan payments (interest and principal) and prepayments.
  • All auto loan-backed securities have credit enhancement, often a senior/subordinated structure.

Credit Card Backed Securities

  • Cash flows consist of finance charges, fees, and principal repayments.
  • Interest (fixed or floating) paid periodically to security holders.
  • Lockout periods exist during which cash flow paid to holders is based only on finance charges and fees; after the lockout period ends, principal is paid to investors.

Fixed Income Portfolio Techniques and Strategies

  • Two major investor categories:
    • Investors without specific liabilities:
      • Often have benchmark return targets.
      • Can adopt active or passive investment management styles.
    • Investors with specific liabilities (e.g., pension, insurance):
      • Need to match liabilities.

Strategies for Managing Fixed Income Portfolios

  • Five major strategies against a bond market index (ranging from passive to active):

    • Passive Management: Assumes market efficiency is high. Managers try to mimic an index.

    • Active Management: Manager's skill is used to exploit opportunities and increase return relative to benchmark.

Passive Management Styles

  • Pure Bond Indexing (Full Replication Approach):
    * Duplicate the index by owning all bonds in the same percentages.
    * Many bonds in typical index are illiquid and thinly traded.
    * Difficult and expensive to implement.
    * Much less common approach than in equities where it is much easier to implement.
  • Enhanced Indexing by Matching Primary Risk Factors:
    • Uses a sampling approach to match the primary risk factors in a benchmark.
    • Primary Risk Factors: changes in the level of interest rates, twists in the yield curve, sector allocations and changes in the spread between Treasuries and non-Treasuries.
    • Less expensive than full replication of index.

Enhanced Indexing by Small Risk Factor Mismatches

  • Style typically matches duration of index while altering other risk factors to achieve superior returns relative to index.
  • Manager may attempt to increase returns by pursuing relative value in certain sectors, credit quality, term structure etc.

Active Management Styles (Larger Risk Factor Mismatches)

  • Active Management by Larger Risk Factor Mismatches:
    • Deliberately make larger mismatches on primary risk factors.
    • Actively pursue opportunities in the market when they arise.
    • Examples: Overweight corporates vs treasuries, duration mismatch, yield curve exposure.
    • Need to generate sufficient returns to overcome expense and risk.
  • Full Blown Active Management:
    • Aggressive mismatches versus index.
    • Benchmark can be bond index or hurdle rate (Libor).
    • Aggressive mismatches on duration, sectors, credit risk, liquidity etc.
    • Often used by Fixed Income Hedge fund managers.

Common Bond Indexes

  • Global:
    • (Bank of America) Merrill Lynch Global Bond Index
    • Bloomberg/Barclays Capital Aggregate Bond Index
    • Citi World Broad Investment-Grade Bond Index (WorldBIG)
  • U.S. Bonds:
    • (Bank of America) Merrill Lynch US Broad Market Index
    • Bloomberg/Barclays US Aggregate Bond Index
    • Citi US Broad Investment-Grade Bond Index (USBIG)
  • Emerging Market Bonds:
    • J.P. Morgan Emerging Markets Bond Index
    • Citi Emerging Markets Broad Bond Index (EMUSDBBI)
  • High-Yield Bonds:
    • (Bank of America) Merrill Lynch High-Yield Master II
    • Bloomberg/Barclays High-Yield Index

Challenges with Bond Indexes

  • Many bond indices are not easily replicated and investable.
  • Most bond issues have less-active secondary markets compared with equities.
  • Bond indices that appear similar can have very different composition and performance.
  • Index composition tends to change frequently.
  • The “bums” problem arises when capitalization-weighted bond indices give more weight to issuers that borrow the most.
  • Investors may not find an index that matches their risk profile.

Managing Fixed Income Portfolios Against Liabilities

  • Approaches:
    • Dedication Strategies
      • Cash Flow Matching
    • Immunization
      • Single Period Immunization
      • Multiple Liability Immunization
      • Immunization for General Cash Flows

Dedication Strategies

  • Often used by pension funds, banks, and insurance companies to match bond portfolio assets with liabilities.

Dedication: Cash Flow Matching Strategies

  • Designed to exactly (or closely) match cash flows of assets with liabilities.
  • Conceptually, a bond is selected with a maturity that matches the last liability, and an amount of principal equal to the amount of the last liability minus the final coupon payment is invested in this bond.
  • The remaining elements of the liability stream are then reduced by the coupon payments on this bond, and another bond is chosen for the next-to-last liability, adjusted for any coupon payments received on the first bond selected. This sequence is continued until all liabilities have been matched by payments on the securities selected for the portfolio.

Cash Flow Matching Considerations

  • If liability flows were perfectly matched by asset flows, the portfolio would have no reinvestment risk.
  • Perfect matching is unlikely given typical liability schedules and available bonds.
  • A minimum immunization risk approach should be as good as cash flow matching and likely will be better because an immunization strategy would require less money to fund liabilities.

Immunization

  • Creating a fixed-income portfolio that produces an assured return for a specific time horizon, irrespective of any parallel shifts in the yield curve.
  • Setting the duration of the portfolio equal to the specified portfolio time horizon (duration matching) assures the offsetting of positive and negative incremental return sources under certain assumptions, including the assumption that the immunizing portfolio has the same present value as the liability being immunized.

Immunization Strategy

  • Should be dynamic and rebalanced because portfolio duration changes with market yield changes and time.
  • The investor’s goal might be to reestablish the dollar duration of a portfolio to a desired level.
  • A portfolio’s dollar duration is equal to the sum of the dollar durations of the component securities.
  • Dollarduration=0.01×Portfoliovalue×DurationDollar duration = 0.01 \times Portfolio value \times Duration

Immunization Rebalancing Steps

  • Steps:
    1. Move forward in time and include a shift in the yield curve. Using the new market values and durations, calculate the dollar duration of the portfolio at this point in time.
    2. Calculate the rebalancing ratio by dividing the desired dollar duration by the new dollar duration. If we subtract one from this ratio and convert the result to a percent, it tells us the percentage amount that each position needs to be changed in order to rebalance the portfolio.
    3. Multiply the new market value of the portfolio by the desired percentage change in Step 2. This number is the amount of cash needed for rebalancing.

Immunization Rebalancing Example

  • Initial portfolio of three bonds with $1\$1 million par value each had a dollar duration of $111,945\$111,945. After a shift in the interest rate, the portfolio values are as follows:

    • Calculate the rebalancing ratio and cash required for rebalancing to maintain dollar duration at the initial level.

Immunization Continued…

  • To calculate the rebalancing ratio:

    • Rebalancing requires each position to be increased by 35.6%35.6\%. To calculate the cash required for this rebalancing:

Spread Duration

  • Measure of how the market value of a risky bond (portfolio) will change with respect to a parallel 100 bp change in its spread above the comparable benchmark security (portfolio).
  • Important for managing spread risk.
  • Spreads do change, and the portfolio manager needs to know the risks associated with such changes.

Extensions of Classical Immunization Theory

  • Extend to nonparallel shifts in interest rates: Use key rate duration, or develop a strategy that can handle interest rate changes without specifying duration.
  • Overcome limitations of a fixed horizon.
  • Analyze risk and return trade-off for immunized portfolios.
  • Integrate immunization strategies with elements of active bond portfolio management strategies.
  • One strategy is called “contingent immunization,” which provides a degree of flexibility in pursuing active strategies while ensuring a certain minimum return in the case of a parallel rate shift.

Risks in Immunization

  • With changes in the market, the portfolio manager faces the risk of not being able to pay liabilities when they come due. Three sources of this risk:

    • Interest rate risk: Prices of most fixed-income securities move opposite to interest rates.

    • Contingent claim risk: When a security has a contingent claim provision.

    • Cap risk: The manager is at risk of the level of market rates rising while the floating-rate asset returns are capped.

Immunization Considerations

  • Immunization with respect to a single investment horizon is appropriate where the objective of the investment is to preserve the value of the investment at the horizon date.
  • For multiple liabilities, there must be enough funds to pay all the liabilities when due, even if interest rates change by a parallel shift.
  • Matching the duration of the portfolio to the average duration of the liabilities is not a sufficient condition for immunization in the presence of multiple liabilities.

Multiple Liability Immunization

  • Necessary and sufficient conditions to assure multiple liability immunization in the case of parallel rate shifts:
    1. Present value of assets equals present value of liabilities.
    2. Duration of portfolio equals duration of liabilities.
    3. Distribution of durations of individual portfolio assets must have a wider range than the distribution of the liabilities.

Immunization for General Cash Flows

  • The assumption is that the investment funds are initially available in full.

    • A strategy can be constructed to deal with this issue:

      *The expected cash contributions can be considered the payments on hypothetical securities that are part of the initial holdings. The actual initial investment can then be invested in such a way that the real and hypothetical holdings taken together represent an immunized portfolio.

Return Maximization for Immunized Portfolios

  • The objective of risk minimization for an immunized portfolio may be too restrictive.
  • If a substantial increase in the expected return can be accomplished with little effect on immunization risk, the higher-yielding portfolio may be preferred.
  • The required terminal value, plus a safety margin in money terms, will determine the minimum acceptable return over the horizon period.

  • The difference between the minimum acceptable return and the higher possible immunized rate is known as the cushion spread.