2024 L1 Fixed Income Flashcards
(110 cards)
1
Q
What is fixed income?
A
- Debt, such as loans and bonds
- Includes private agreements between borrower annd lender, ie individuals and corporations and banks or funds
- Also includes public securities i.e., many lenders, one borrower. When you buy a treasury you are actually lending the govt money. This involves investors as lenders, and corporations and govts as borrowers
- All fixed income involves periodic interest payments plus principal
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
2
Q
What is a capital market security?
A
- A bond with greater than 1yr initial maturity at issuance
- Less than 1yr is a money market security
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
3
Q
What is an amortising bond?
A
- Payments over the life of the bond also include principal.
- This is contrasted to a bullet bond where the whole principal is paid at the end
- MBS often include principal in every coupon payment
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
4
Q
What is a floating coupon?
A
- Coupon payment by the bond varies i.e., US treasury rate plus 2%
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
5
Q
What is seniority?
A
- Position of the bond in the capital structure (i.e., priority of claim or assets)
- Senior secured is highest, then senior unsecured
- All senior unsecured ranks equally
- Junior or subordinated debt is next
- Contingency provisions are often included in lower quality debt that alow for an action if an event or circumstance happens. I.e., calls, puts, or convertibility to equity
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
6
Q
What are premium, discount, and par bonds?
A
- Premium bonds are where price is above par. The yield is less than the stated coupon payment. This will happen if rates fall from when it was issued.
- Discount bonds are where price is less than par. Yield is greater than coupon. This will happen if rates rise from when it was issued
- Par bonds are where price = par price and yield = coupon stated.
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
7
Q
Why is bond IRR affected by interest rate changes?
A
- IRR assumes coupon is reinvested at YTM rate
- Therefore if interest rates change the rate might increase or decrease
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
8
Q
What is a bond indenture?
A
- The legal contract for a bond
- Contains form of the bond, obligations of the issuers, rights of bondholders, SOURCES of repayments
- For sov govts, taxation and printing currency
- For local govts, taxes and project cash flows
- For corporations, operating cash flows to pay interest and principal
- Plus for all, pledge of specific assets when secured bond
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
9
Q
What are the 2 types of bond covenants?
A
- Affirmative and negative
- Affirmative impose no cost or restriction on operating the biz
- States what the issuer is required to do, usually administrative
- Often includes passi passu clause: equal footing for senior unsecured debt
- Also poften includes cross default clause: a default on one is a default on all
- Negative imposes costs and restrictions on operating the biz
- I.e., might ask if secured that you will not pledge any other asset
- There might be restrictions on issuance of debt more senior (negative pledge clause)
- There may be limitations on additional debt
2024 L1 Fixed Income - LM1 Fixed-Income Instrument Features
10
Q
What does a fully amortising bond look like?
A
- Equal amount of principal paid on each payment
- Interest payment drops each time as the total principal decreases
- Therefore total payment starts high and decreases
- Higher reinvestment risk, in the case that rates are falling and what you reinvest you get returns on at a lower risk
- But you also get decreasing credit risk, as the payments are covering your principal too
- A bullet bond is where the full principal is paid back at maturity
2024 L1 Fixed Income - LM2 Fixed Income Cash Flows and Types
11
Q
What is a partially amortising bond?
A
- Part of the principal is amortised, part is paid back at the end
- ie half the principal amortised, half paid back at the end
2024 L1 Fixed Income - LM2 Fixed Income Cash Flows and Types
12
Q
Along what 3 dimensions can fixed income markets be categorised?
A
- Issuer type (sector)
- Credit quality
- Time to maturity
2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading
13
Q
Do treasuries have risk?
A
- Yes, they still have risk
- But not default risk
2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading
14
Q
What are the components of credit quality?
A
- Probability of default (PoD)
- Loss given default (LGD)
These are summarised by the credit rating, a qualitative letter-based measure that combines both PoD and LGD
2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading
15
Q
What are the largest rating agencies?
A
Moody’s and S&P
2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading
16
Q
What are fallen angels?
A
- Debt issuers that drop below BBB- to BB+ or higher
- They move from investment grade to high yield
- High yield is sometimes called junk or speculative bonds because in the 80s when the market was created it was rare for companies to issue bonds
- Therefore people thought they would be high risk
- High yield bonds can be high quality especially at the top ie BB+
2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading
17
Q
Why do fixed income indices exist?
A
- Track broad risk/return of different markets
- Enable evaluation of market performance
- Benchmarks for portfolios and investment managers
- Form the basis for indexed instrument strategies and products
2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading
18
Q
What are the differences between equity and bond indexes?
A
- Bond indexes have many more constituents
- Far more changes (issuance, maturity, monthly rebalancing)
- Market value of debt weighted
- Bond funds rarely hold all bonds, and instead use sampling
- Bonds are priced once a day: it’s a dealer market and there is no minute to minute pricing
- There will be monthly rebalancing
2024 L1 Fixed Income - LM3 Fixed Income Issuance and Trading
19
Q
What are the types of lines of credit?
A
Uncommitted, committed (regular), and revolving credit agreements (i.e., revolvers)
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
20
Q
What is an uncommitted credit line?
A
- Banks can cancel anytime
- Least reliable source
- Up to a certain amount (credit line) for a maximum period of time (less than 1yr)
- Floating credit plus spread
- No costs other than interest payments
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
21
Q
What is committed credit?
A
- A formal written commitment from the bank
- Max term is less than 365 days, and then you must finish paying off the credit
- i.e., rest the line
- Will involve a commitment fee on the full or unused amount
- Borrower does face renewal risk
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
22
Q
What is a revolving credit agreement?
A
- Multi-year agreement
- You must ‘rest the line’ and pay off the loan every year
- However you don’t have rollover risk
- The bank will add covenants (lender protections)
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
23
Q
What are the kinds of secured loans?
A
- Secured loans: asset backed loans (fixed assets, high quality receivables, marketable securities)
- Factoring: selling accounts receivable, typically at a discount (the factor collects the AR payments)
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
24
Q
What is commercial paper?
A
- usually less than three months
- Issued by large highly rated firms
-Typically rolled over (which introduces rollover risk) - usually requires a backup line of credit (committed)
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
25
What are sources of funding for financial companies?
- desposits: household or commercial operational deposits. Checking accounts, demand deposits that pay little to no interest. No duration or maturity, but they do have a behavioural maturity (fee rebates, min balances)
- Savings deposits: ie a certificate of deposit like a CD or term deposit. Less than 1yr maturity, pays interest at maturity.
- Interbank market: short term lending/borrowing among financial institutions as either secured or unsecured. Overnight to 1yr at market maker rate. Interbank rate is used to price derivatives (ie between large investment banks) because they are the market makers. Banks hold funds with the central bank (reserves). Excess reserves can be lent in the CB funds market
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
26
27
How does the Fed control interest rates?
- By setting an upper and lower bound between which all interbank lending rates much fall
- i.e., CB lends money at 5%, borrows money at 4.75%. Therefore any bank cannot set interbank rates beyond this range since otherwise someone will go to the CB instead
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
28
What is commercial paper?
- Unsecured debt
- Dominated by large financial institutions (about 60% pa)
- asset backed commercial paper (ABCP) is off balance sheet. There is less capital required for banks, the upside for investors being that they get access to bank loan returns
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
29
What are repos?
- Secured short term funding
- The pledge of a security under a repurchase agreement
- Not exactly a security in itself
- It could be a bond or MBS
- If you want to maximise value you use sovereign bonds
- It looks like you are selling and repurchasing it but really you retain ownership during the repo term
- The buyer just gets the repo rate
- There is usually something called a haircut where the cash lender will not give you the full amount back
- Under repo, you get the same security back, under a dollar roll, you get a slightly differet one
- When you post general collateral you pay the general collateral repo rate, which is typically higher than the specific collateral repo rate
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
30
What is the variation margin?
The value of the haircut which makes the repo overcollateralised
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
30
Why use repos?
- Finance ownership of a security (for asset owners. Gives high leverage with less rollover risk than overnight borrowing)
- earn short term income by lending funds on a secured basis (for lenders)
- Borrow a security in order to short it (reverse repo)
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
31
What is a reverse repo?
1. Borrow a security and give cash
- Typically a 'special' security i.e., an on the run bond (higher rate) which can become a lower rate one
- Typically negative repo rates: security buyer pays interest
2. you call sell the security and get cash (and earn the cash rate)
3. you could buy the security back, hopefully at a lower price
4. You return the security, and get back the cash, less the reverse repo rate
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
32
What are repo rates affected by?
1. Money market interest rates
2. Collateral quality
3. Repo term
4. Collateral uniqueness - more unique, lower the repo rate
5. Collateral delivery: higher rate if collateral is not delivered
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
33
What are the risks for repo?
1. Default risk: counterparty not repurchase
2. Collateral risk: w low quality collateral
3. Margining risk: counterparty may not meet margin calls if collateral drops in value
4. Legal risk: you don't have a formal legal ownership claim
5. Writing/settlement risk: money and collateral might not actually transfer. A heavy reliance on repo market can create rollover and liquidity risks under adverse market conditions
Risks can be reduced by using a triparty repo, where the triparty has collateral and holds the cash and securities as the custodian
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
34
What is the tradeoff between duration and rollover risk of corporate debt?
- Higher yields over longer maturities usually
- However when you issue short term debt if spreads jump this creates rollover risk. Sudden increase when you return to get more debt
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
34
Why do high yield bonds have low sensitivity to increases in rates?
- They have more distance from the risk free rate so value should not fall as much
## Footnote
2024 L1 Fixed Income - LM4 Fixed Income Markets for Corporate Issuers
35
What is the composition of govt debt?
- Short term: 1-12 months T bills
- Medium term to long term: Notes, bonds, fixed rate generally. Limited issuance of FRNs, Treasury Inflation Protected Securities
- Govt guarantees: govt agency debt (i.e., Ginnie Mae, the agency for mortgage backed securities)
## Footnote
2024 L1 Fixed Income - LM5 Fixed Income Markets for Government Issuers
36
## Footnote
2024 L1 Fixed Income - LM6 Bond Valuation: Prices and Yields
37
What is the trade off between coupon and price stability for floating vs fixed rate bonds?
- Floating rate usually = more stable price
- fixed rate usually = changing price
## Footnote
2024 L1 Fixed Income - L8 Yield and Yield Spread Measures for Floating-Rate Instruments
38
How to calculate present value of a T-Bill?
PV = FV x (1 - days/year x DR)
- Where PV = present value
- FV = future value
- DR = discount rate
## Footnote
2024 L1 Fixed Income - L8 Yield and Yield Spread Measures for Floating-Rate Instruments
39
What is the maturity effect?
- Longer the tenor of the bond, the greater the % change in present value for a given change in yield
- The one exception is low yield, long-term bonds sold at a discount
## Footnote
2024 L1 Fixed Income - LM6 Bond Valuation: Prices and Yields
40
What is the constant yield price trajectory?
- Bond prices change with the passage of time
- Converge to par
- Premium or discount bonds are pulled to par
- Holding all else constant: as interest rate changes may overpower this effect
## Footnote
2024 L1 Fixed Income - LM6 Bond Valuation: Prices and Yields
41
What is the convexity effect?
- % change for a price of a bond for a drop in rates is GREATER than the % change for a price of a bond for an increase in rates
- This is because of the size of the gap between the CONVEX price-yield curve and the LINEAR downward sloping line that ezpresses changes in income
## Footnote
2024 L1 Fixed Income - LM6 Bond Valuation: Prices and Yields
42
What is matrix pricing?
- Matrix pricing used when bonds have no current market price
- This could either be because they are illiquid, or because they have not yet been issued
- We use linear interpolation to estimate yield to maturity and therefore calculate price
## Footnote
2024 L1 Fixed Income - LM6 Bond Valuation: Prices and Yields
43
How do we calculate matrix pricing?
1. Identify comparable bonds: similar by time to maturity, credit rating
2. Calculate yield to maturity (YTM) for each, and average YTM by maturity
3. Use linear interpolation
4. Use estimated YTM to calculate price
## Footnote
2024 L1 Fixed Income - LM6 Bond Valuation: Prices and Yields
44
What is a Bermuda call option?
- A bond for which there are multiple dates on which you can call the bond before it reaches maturity
- Calling the bond = redeeming a set amount of money
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
45
How do you calculate yield to call for bonds with embedded Bermuda call options?
- When calculating value of bonds with Bermuda call options, we calculate value until first call. second call, third call call separately
- Calculate yield to first call with first call at end of year 3 = treat as 3-year bond
- do separately from beginning of year 1 to call year for each one
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
46
How are callable bonds typically quoted?
- yield to worst: yield to the lowest out of the yield to first call, second call, third call etc
- Just select the lowest, and this becomes yield to worst
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
47
What are the components of spread?
- Spread IS risk premium
- Within risk premium there are tax risk, liquidity risk, and credit risk
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
48
Which component of risk premium do we assume accounts for the whole risk premium when working with credit risky bonds?
- We assume the entire risk premium is CREDIT RISK for risky bonds
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
49
What are the components of the risk-free rate of return?
- Expected inflation rate, plus:
- expected real rate
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
50
What factors affect spread of a bond?
- Microeconomic factors
- These are factors related to the characteristics of the issuer and characteristics of the bond itself
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
51
What factors affect the benchmark rate?
- Macroeconomic factors
- These factors are related to:
- General economic growth
- Stage of the business cycle
- Fiscal policy
- Monetary policy
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
52
Is the benchmark rate constant?
- No, benchmark rate varies across financial markets
- Some economies have more macroeconomic risk than others (i.e., EMs)
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
53
What is an I-spread?
- Means of calculating benchmark rate but using swap rates (interbank rates)
- For bonds of same currency and same tenor
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
54
What is a z-spread?
- Zero volatility spread
- I.e., a constant spread over each spot rate
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
55
What is the most common way of calculating spread?
- Option adjusted spread (OAS)
- Requires a pricing model, plus estimate of interest rate volatility
## Footnote
2024 L1 Fixed Income - LM7 Yield & Spread Measures for Fixed Rate Bonds
56
What is credit risk?
Risk of loss due to default
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
57
What are the 3Cs of top-down credit risk?
1. Country (geopolitical, legal, domestic affairs)
2. Conditions (macro environment)
3. Currency (domestic vs foreign)
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
58
What are the 5Cs of bottom up credit risk?
1. Capacity (ability to service debt)
2. Capital (level of equity)
3. Character (quality of mgmt)
4. Covenants (legal terms of debt agreement)
5. Collateral (quality and value of assets)
Capacity and capital are quantitative, the others are qualitative
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
59
How do you calculate loss given default (LDG)?
Expected Exposure x (1 - Recovery Rate) = Loss Given default
Where EE = Total projected exposure under event of default
RR = Percentage of loss recovered in default
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
60
How do you calculate expected exposure?
Principal + accrued interest
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
61
What does overcollateralised?
- The amount of collateral forfeitied to take out the loan is worth greater than the value of the loan
- In this case loss given default to the lender might actually be nothing: the lender could even earn money
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
62
What is probability of default?
Conditional probability of borrower default (assuming no prior default)
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
63
What is Expected Loss (EL)?
- Probability-weighted amount of loss on a loan
- An annualised measure
Loss Given Default x Probability of Default = Expected Loss
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
64
What is credit migration risk?
- Risk that the issuer of debt which you have already borrowed from will be later downgraded
- If their credit rating is downgraded your debt devalues, giving unrealised losses
- This is because debt would now be issued at higher rates to compensate for higher perceived risk
- Even if you believe there are the same chances of the debt being repaid, downgrades and upgrades still affect the value of your debt
- Therefore credit migration risk describes this phenomenon
- (obviously, if there is an upgrade, this increases the value of your debt!)
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
65
In what way are credit ratings sticky?
- They lag market pricing of credit risk
- Rating outlooks (i.e., positive or negative) are more timely with market conditions
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
66
What risks are difficult to capture in credit ratings?
- Litigation
- Environmental risks
- Natural disasters
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
67
Why might credit ratings diverge between providers?
- More bearish or bullish on litigation outcomes
- Larger weight paid to tail risks like environmental or natural disasters
- Credit ratings are also created so humans, so naturally, are prone to error
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
68
What is credit spread risk?
- risk of greater expected loss due to changes in credit conditions
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
69
What affects the yield spread?
- The business/credit cycle
- During economic expansion, spreads contract
- They are at their narrowest at the peak
- During contraction, spreads widen
- Spreads are widest at the trough
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
70
Why might adding credit risk to a portfolio be desirable?
- Portfolio diversification: in a bond portfolio high yield assets are less correlated with investment grade
- Risky bonds behave like equities (introduce equity like returns)
- This is because the price increases during economic expansion (though the yield falls)
- Govt bonds are the opposite: they increase in price as rates go down (safe bet during recession), whilt they decrease in price as rates go up (less attractive during a boom)
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
71
Why is high yield not a good diversifier in an equity portfolio?
- They perform like equities, increasing in price during economic expansion
- Therefore they are too closely correlated
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
72
Why do govts issue debt?
- Conduct fiscal policy
- Meet budgetary needs
- It's less risky when govts do the former
- If govts take out debt to finance projects that boost growth (i.e., infra) then debt is offset by that growth
- If debt is issued to meet budgetary needs, this implies that there will either have to be austerity or a credit realisation in future
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
73
What qualitative factors impact creditworthiness?
1. Govt institutions and policy
2. Fiscal flexibility: discipline over time and under different economic scenarios
3. Monetary effectiveness: level of independence, record of sustainable growth with price stability
4. Economic flexibility: level of per capita GDP, size of informal economy (difficult to collect taxes)
5. External status: reserve currency status
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
74
What quantitative factors impact creditworthiness of countries?
- No financial statements
- Low comparability between countries
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
75
What are the 3 types of ratio which can be used to assess a firm's ability to service debt from operations?
- Profitability (i.e., operating income to revenue. Also known as EBIT margin)
- Coverage ratios (i.e., Operating income to interest expense)
- Leverage ratios (i..e, debt to EBITDA)
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
76
Why is only the mean recovery rate not a useful statistic?
- It's also important to know the distribution
- A same or even slightly lower recovery rate but with a tighter distribution (lower variance) is preferable to a recovery rate with a wide distribution (high variance)
## Footnote
2024 L1 Fixed Income - LM14 Credit Risk
77
Why do investment grade debt issuers mostly issue senior unsecured debt?
Because investors are less concerned about default risk.
High yield debt is where investors typically require debt to be secured in order to make a purchase
## Footnote
2024 L1 Fixed Income - LM16 Credit Analysis for Corporate Issuers
78
Why might senior debtholders offer concessions to junior debt holders during bankruptcy of an issue?
- To save on legal and accounting fees (billable hours
- minimise customer flight
## Footnote
2024 L1 Fixed Income - LM16 Credit Analysis for Corporate Issuers
79
What is structural subordination?
- The debt of a holding company is structurally subordinate to the debt of its operating companies
- This is because cash flows from debt service the operating companies first
- Only after OpCo debt has been serviced can cash flow up to the HoldCo
## Footnote
2024 L1 Fixed Income - LM16 Credit Analysis for Corporate Issuers
80
What is securitization in fixed income?
- A lender issues a bunch of loans
- It groups these loans together and sells them to an SPE
- The SPE issues asset backed securities to investors
- investors get the cash flows from the loans, while the bank gets to shift the loans off their balance sheet
## Footnote
2024 L1 Fixed Income - LM17 Fixed Income Securitisation
81
What are covered bonds?
- Assets are securitised but remain on the bank balance sheet
- Bank ringfences certain eligible loans to create the cover pool
- Typically commercial or residential mortgages
- Issuer must replace any pre-paid or non-performing asset
- Typpically overacollateralised: the cover pool value is greater than the value of the covered bonds issued
- Asset monitor reviews the cover pool
- Covered bond investors take the interest and principal repayments
- Loan to value ratio must meet certain standards
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
82
What is the different between hard bullet and soft bullet covered bonds?
- With hard bullet, payments are accelerated when default happens
- Issuer sells loans to meet the full redemption amount
- With soft bullet, payments are delayed with default or lack of prepayments
- The final redemption date is extended instead, usually up to 1yr
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
83
What are conditional pass through covered bonds?
- Covered bonds where they convert to pass-through after the original maturity date
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
84
What is overcollateralisation?
- A type of credit enhancement (to increase quality)
- For ABSs, the bank may retain a small equity position in the SPE which issues the securities
- This means a buffer in case of default
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
85
What is excess spread?
- A type of credit enhancement (improves quality)
- Excess spread is where the average coupon on the underlying collateral (aggregate interest collected) is less than the avg coupon on the bonds (aggregate interest paid
- There may be a 150bps cushion to absorb losses or build up reserves. The excess cash would accrue to the equity slice
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
86
What is subordination, aka tranching?
- A type of credit enhancement (improve quality)
- Any principal flows to the senior bonds first, then to junior
- It's a waterfall approach
- Interest flows to all tranches
- The lower the tranche (higher credit risk involved) the higher the interest payment
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
87
What are CDOs?
- Backed by a diversified pool of one or more debt obligations
- If corporate or EM bonds, it's a CBO
- If leveraged loans, it's a CLO
- If other CDOs, it's a structured finance CDO
- If CDSs on other CDOs, it's a synthetic CDO
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
88
What is the difference between a cash flow CLO (the most common) and a market value CLO?
- If the value of the underlying debt depreciates, this matters for a market value CLO but not for a cash flow CLO
- For a cash flow CLO, only the cash flows matter. If the interest and principal continues to be repaid then nothing changes
- For a market value CLO, the value of the underlying debt on the market does matter
- Where this becomes relevant is during overcollateralisation test. Many CLOs are overcollateralised, i.e., value of collateral exceeds value of CLO debt (more in the pot than they pay out)
- For market value CLOs they can fail the regular overcollateralisation test due to a market value drop in the debt
- For cash flow CLOs this is not the case
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
89
What is the warehouse period?
- The 6-12 months before the close of the CLO when the provider is getting together the loans used to make the CLO
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
90
What is the ramp-up period?
- Period after CLO close when excess CLO funds are used to acquire more loans
- Not all the loans are bought at once
## Footnote
2024 L1 Fixed Income - LM18 Asset-Backed Security (ABS) Instruments
91
What is contraction risk?
- The risk that you will get your money back from lending too soon
- When interest rates drop borrowers refinance at a lower rate
- Therefore mortgage backed securities' maturity will be shorter
## Footnote
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What is extension risk?
- When rates rise, prepayments slow
- This extends maturity of a mortage backed security, which therefore increases duration
- Lower cash flows for reinvestment when rates are higher
- To aboid this, MBSs can be time tranched
## Footnote
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What is an agency MBS?
- mortgage backed security guaranteed either with a government/federal agency
## Footnote
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What are prepayment penalties used for?
- To mitigate prepayment risk for the lender (which decreases maturity and therefore duration)
- Common in Canada and Europe, not so much US
## Footnote
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What is the difference between recourse and non-recourse?
- Recourse means the lender has a claim against the borrower in default
- If loan to value is greater than 1 then lender can seek personal liability
- Non-recourse means lender only has a claim against the house
- This introduces possibility of strategic default: borrower defaults to avoid paying loan on property that is worth less than the loan
- Non-recourse common in US
## Footnote
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How do you calculate weighted average coupon of an MBS?
- MortgageRate1 x MortgageVal1/SumOfPool + MortgageRate2 x MortgageVal2/SumOfPool....
## Footnote
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How do you calc weighted average maturity of an MBS?
- MthsRemaining1 x MortgageVal1/SumOfPool + MthsRemaining2 x MortgageVal2/SumOfPool....
## Footnote
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What backs a collateralised mortgage obligation?
Mortgage-backed securities
## Footnote
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What is a z-tranche?
- Tranche of a CMO for which there is no principal or interest repayment until a set date
- Typically greater than 20 years average life
- Typically the last tranche in a time tranche MBS
- P and i accrue, but are not paid out
## Footnote
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What are principal-only securities?
- CMO securiites which only pay out principal
- Sold at a discount to its principal value
- Highly sensitive to prepayments and therefore interest rates
## Footnote
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What are interest-only securities?
- CMO securities which pay out interest only
- No face val or par val
- As prepayments increase, future cashflows decline
## Footnote
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What are floating rate tranches?
- CMO tranches where payment out is floating
- Often subject to both cap and floor
- Can also be structured as an inverse floater (goes down when rates go up)
## Footnote
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What are residual tranches?
- Collects payment after payment to all other tranches complete
## Footnote
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What is defeasance?
- A portfolio of govt securities is purchased that fully replicates the remaining cash flows of the mortgage (not the CMBS)
## Footnote
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What is a balloon maturity provision?
- Commercial real estate loans are not fully amortising
- Payments are interest, and maybe some principal
- Remaining principal can be at end of y5 or 10
- Creates risk that borrower cannot sell property to meet balloon amount, cannot meet in other ways, or cannot rollover
- If this is the case lender may extend the loan, which may create extension risk
## Footnote
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What are the risks of commercial MBSs?
- Concentrated pool of loans: a few, and heterogeneous
- A single default can have significant impacy
- DD involves analysis of the underlying loan pool
## Footnote
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How to calculate debt service coverage ratio?
Net operating income / debt service
- Where debt service = p + i
- and Net operating income = (income - cash expenses)
- DSCR is a key indicator of credit performance.
- DSCR should be greater than 1. Higher the better.
## Footnote
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