Section 3: US Government Debt

U.S. Government Securities Are Exempt From The Securities Acts

Note that U.S. Government bonds and the market participants are exempt from regulation under the Securities Act of 1933; and the Securities Exchange Act of 1934. Thus, the Securities and Exchange Commission does not oversee U.S. Government bond trading. However, the Federal Reserve, in its regulation of banks (who are large participants in this market), does have an oversight role. Also note that savings bonds (EE Bonds) are NOT part of this market - they are non-negotiable and cannot be traded. They are bought from the government and can only be redeemed with the government.

Companions Are Most Risky

The Companion tranches are the "shock absorbers" that surround the PAC tranche. They absorb prepayment risk and extension risk out of the PAC. The Companion tranches have the highest risk and are offered at higher yields.

Federal Reserve As Dealer / New York Fed Trading Desk

The Federal Reserve maintains its own trading account and buys and sells large quantities of government securities in the market to manage interest rates. This activity is called "open market operations" and is discussed later in the text. The New York "Fed" has a trading floor where it trades every day with the primary government dealers.

PO Prices Move Opposite To Market Interest Rates Like A Regular Bond

A PO's price volatility works in the same manner as a long-term bond. If market interest rates rise, prepayment speeds will decrease (extension risk) and the maturity will lengthen, so the bond's price will decrease. If market interest rates fall, prepayment speeds will increase (prepayment risk) and the maturity will shorten, so the bond's price will rise.

Planned Amortization Class / Companion Class

A newer version of a CMO has a more sophisticated scheme for allocating cash flows. Newer CMOs divide the tranches into PAC tranches and Companion tranches. The PAC tranche is a "Planned Amortization Class." Surrounding this tranche are 1 or 2 Companion tranches.

Agency Bond Quotations

Agency securities are quoted in identical fashion to long-term U.S. Government securities (T-Notes and T-Bonds). No narrative is given since the format is identical to that just discussed.

Interest Payments Applied Pro-Rata / Principal Payments Applied Sequentially

As monthly interest payments are received, the interest is distributed pro-rata to all the tranches. However, as principal is repaid, the principal repayments are first applied to Tranche 1 securities. Since repayment rates can be well estimated, the dollar size of Tranche 1 is set so that expected repayments from 1 to 3 years retire that tranche. After Tranche 1 is retired, principal repayments then are used to retire Tranche 2 starting in the 4th year, etc. By "recutting" the cash flows received from the mortgage pool, investors can now buy a mortgage backed security with a wide range of maturities. In addition, prepayment risk is reduced, since principal payments are applied sequentially to the Tranches.

Monthly Mortgage Payments Passed Through To The Certificate Holder

As mortgage payments are received from the pooled mortgages, the payments are funneled to the certificate holders. Payments are made monthly, with each payment representing a portion of principal and interest (since these are mortgage payments). The certificates are self-liquidating as the mortgages are paid off.

High Level Of Interest Rate Risk

Because these are long-term zero-coupon (deep discount) obligations, price swings are very volatile as interest rates move. This security is highly susceptible to interest rate risk. But, purchasers are not too worried about this since STRIPS are usually held to maturity.

$1,000 Denomination

CMOs are available in $1,000 denominations, as opposed to pass through certificates that are $25,000 denominations. This makes CMOs more accessible to small investors.

Cash - Same Day

Cash settlement for U.S. Government and Agency trades is the same business day, before 2:30 PM .

Collateralized Mortgage Obligation

Collateralized mortgage obligations (CMOs) were developed to eliminate or minimize these risks. CMOs do not view mortgage pools as a means of passing through payments to certificate holders in exactly the same form as received.

Debt Rated AAA (Moody's) Or AA (Standard + Poor's)

Due to its bankruptcy and placement in government conservatorship in 2008, its stock was delisted and now trades in the Pink Sheets for around $2 per share. However, Freddie Mac debt obligations are implicitly backed by the Federal government and are still rated AAA by Moody's and AA by Standard and Poor's.

Debt Rated AAA (Moody's) Or AA (Standard + Poor's)

Due to its bankruptcy and placement in government conservatorship in 2008, its stock was delisted and now trades in the Pink Sheets for well under $1 per share. However, Fannie Mae debt obligations are implicitly backed by the Federal government and are still rated AAA by Moody's and AA by Standard and Poor's

Private Label CMOs

However, broker-dealers still package CMOs in great numbers, using both Agency MBSs and other mortgage-backed securities as collateral. Broker-dealer created CMOs are now called "Private Label" CMOs, because they contain a mix of MBSs as collateral. The broker-dealer can use Agency MBSs as a starting point, and then add MBSs created from non-conforming mortgages that Ginnie, Fannie and Freddie will not buy. These are MBSs where the underlying mortgages are too large in size, so the Agencies will not buy them (so-called "jumbo mortgages") and mortgages to do not meet the Agencies' credit standards (because they are too risky). Thus, the broker-dealer can create a CMO that ranges from very safe to very risky. With these "Private Label" CMOs, the credit rating is assigned by a ratings agency such as Moody's, based on the credit quality of the underlying collateral.

Principal Repayment The Higher Of Par Or The Inflation Adjusted Amount

If the principal amount is adjusted upwards due to inflation, the bondholder receives the higher amount at maturity. Thus, the bond is protected against purchasing power risk. On the other hand, if the principal amount is decreased due to deflation, the bondholder will always receive par at maturity.

Ginnie Mae Pass-Throughs Fully Taxable

In addition, the interest income from Ginnie Mae pass through certificates is fully taxable. (This makes sense since the mortgage interest was deductible by the mortgagee on both of his or her federal and state returns.) (Note: The tax status of the interest income received from Government, Agency, Corporate and Municipal debt instruments is summarized at the end of the Municipals section of this chapter. Also, the tax rules are summarized in the Taxation chapter.)

Not A "Pass Through" / Yields Increase As Maturity Lengthens

Instead of passing through monthly mortgage payments to holders, a formula is used to "recut" the mortgage payments into the appropriate payments for each tranche. Note that each tranche is offered at an appropriate yield for that expected maturity, creating a variety of maturities to meet differing investor needs.

Cash Flow Basis / Tranche

Instead, the mortgage payments received are looked at on a "cash flow" basis. On the basis of expected cash flows to be received over the life of the pool, separate classes of securities called "tranches" ("slices" in French) are created. For example, a 30-year mortgage pool may be broken up into 10 tranches as listed below:

Treasury Notes / Over 1-10 Years / Quoted In 32nds

Intermediate-term securities issued with maturities ranging from over 1 to 10 years. The notes are issued in minimum denominations of $100 par value and pay interest semi-annually to registered holders. Treasury notes are quoted as a percentage of par value in 32nds. Notes are non-callable.

Non-Callable

Long-term Treasury bonds are non-callable. In the past, the Treasury issued long bonds that were callable in the last 5 years of their lives, but they all matured in 2009. Now, all long bonds are non-callable. Over the years, the Treasury introduced variations on Treasury Bonds to meet specific investor needs.

Quoted Through Computer Screens

Quotes for U.S. Government issues are placed by the primary dealers on a computer quotation system through services such as Bloomberg and Reuters.

TIPS - Annual Upwards Adjustment Is Taxable In That Year

Regarding TIPS - Treasury Inflation Protection Securities - if the principal amount is adjusted upwards due to inflation, the adjustment amount is treated as taxable interest income (not capital gains) for that year. Conversely, if the principal amount is adjusted downwards due to deflation, the adjustment amount is treated as deductible interest expense for that year.

Series EE Bonds

Series EE bonds are "savings bonds" issued by the U.S. Government with a minimum purchase amount of $25 (or more). This is the face value of the bond, and any interest earned will be added to the bond's value.

NOT Directly Backed By U.S. Government Except For GNMA

The agencies obtain the funds to buy the mortgages by selling bonds to the public. The U.S. Government does not directly back these issues with the exception of the Government National Mortgage Association. "Ginnie Maes" are directly backed by the government, whereas the other agencies are backed implicitly, not directly. Also note that the Federal Government "takeover" of Fannie and Freddie in the fall of 2008 due to overwhelming mortgage losses still does not mean that these securities are directly government guaranteed. Fannie and Freddie are in a "conservatorship" where their management and operations are controlled by the Federal Government - but their securities are still not government "guaranteed."

Discount On STRIPS Must Be Accreted And Taxed Annually

The discount on long-term so-called "original issue discount" obligations, such as STRIPS, (zero-coupon issues) is treated as annual taxable interest income, pro-rated over the life of the bond. The annual accretion amount (the discount earned) is taxable each year, even though no interest payment has been received from the issuer. Since people don't like to pay tax on income that is not actually received, these securities are held typically in retirement plans (tax deferred envelopes), so that tax is not paid until the monies are withdrawn from the retirement plan.

"Privatized" Agency Debt Fully Taxable

The interest income from securities issued by "privatized" agencies, such as Fannie Mae and Freddie Mac, is fully taxable, similar to regular corporate obligations.

U.S. Governments Initially Offered By Competitive Bid

The market for agency securities is dominated by the primary dealers. Whereas U.S. Government issues are initially sold by competitive bid at a weekly yield auction, (where the bidders are usually the primary dealers), agency securities are issued differently. Each agency has assembled a selling group of firms who market the agency's issues. They act as fiscal agents for the agency.

Sallie Mae

There are other agencies, but the only one that need be known is "Sallie Mae" - Student Loan Marketing Association. "Sallie Mae" purchases insured student loans from qualified lending institutions. Loans are purchased from colleges, universities, state agencies, and banks. Sallie Mae sells normal debentures paying interest semi-annually backed by these loans.

Secondary Market For Home Mortgages

These agencies make a secondary market in home mortgages. They purchase the mortgages from the local banks that originated the loans. This injects new funds into the local banks, allowing them to give more mortgages.

No Reinvestment Risk

This investment is designed for pension fund managers who want a safe, long term investment and who do not want to worry about having to reinvest semi-annual interest payments that could be subject to reinvestment risk (if market interest rates fall during this time period).

Prepayment Risk / Similar To Call Risk

Thus, prepayment risk is greater with mortgage pools having high stated interest rates on the mortgages. When the mortgages are prepaid early, the effect is the same as a bond being called. The investor no longer gets the high interest rate and must reinvest at lower interest rates.

Regular Way Settlement - "Depends" For Agencies

Trades of Agency securities that pay interest semi-annually generally settle "regular way" 1 business day after trade date (though there are some exceptions). Trades of mortgage backed securities (which pay monthly) settle on pre-established dates each month. Because of the complexity of Agency settlements, these are not tested.

Trades Settle In "Fed Funds"

Trades of U.S. Government and Agency securities clear through the Federal Reserve Wire System. These trades settle in "Fed Funds" - good funds immediately payable at a Federal Reserve Branch member institution.

Regular Way Settlement - Next Day For Treasuries

Trades of the U.S. Government Treasury Bills, Notes and Bonds settle "regular way" on the business day after trade date.

Direct Treasury Debt Highest Rating

U.S. Government debt is considered to be the highest rated debt - essentially free of credit risk. (Note that this is still the case, regardless of the Standard and Poor's credit downgrade to AA that occurred in 2011 - the other credit ratings agencies kept the rating at AAA). Agency debt is also highly rated (AAA) but is considered less safe than the direct debt.

T-Bill - Weekly Auction / All Other Treasury Debt - Monthly Auction

U.S. Government debt is sold by competitive bidding at a weekly auction conducted by the Federal Reserve. At the weekly auction, Treasury Bills are sold. This is, by far, the largest amount of debt issued by the government. Every four weeks, notes, bonds, and TIPS (Treasury Inflation Protection Security) are sold at auction. The actual amount of debt for sale at each auction depends on the financing needs of the government. For example, right after April 15th, sales are reduced since the government has just received that year's tax receipts. (Auction procedures are covered in detail in the New Issues chapter.)

Zero (Z) Tranches

Z-Tranches are also known as accrual tranches and do not receive any payments of interest or principal until ALL preceding tranches are retired. This is, in essence, a zero-coupon obligation, and has the greatest price volatility of all tranches. Z-bonds are purchased by investors seeking minimum reinvestment and call risk, but they have greater interest rate risk.

PSA - Prepayment Speed Assumption

Furthermore, each pool of mortgages has an "average" life that is based upon the "experience" that the packagers of pass through certificates have had over long time periods. For example, based on FHA experience tables, most 30-year mortgages are paid off after 12 years. Most 15-year mortgages are paid off after 7 years. This is known as the "PSA" - Prepayment Speed Assumption.

Largest Debt Market

The U.S. Government issues debt in order to finance the running of the government. The market for U.S. Government debt is the largest and most active trading market in the world. Currently, there is over $20 trillion in debt outstanding (our accumulated federal deficit). Negotiable government debt issues take the form of long-term bonds, intermediate-term notes, and short-term notes, known as Treasury Bills

STRIPS Is A Treasury Bond That Is Stripped Of Coupons

"STRIPS" - STRIPS are Treasury Bonds that have been "stripped" of their coupons. These are "zero coupon" Treasury Obligations. The full name is actually a "Separate Trading of Registered Interest and Principal Security," which is a fairly indecipherable phrase. To understand where the name "STRIPS" came from, let's take the picture of a coupon bond shown earlier in this chapter and use it to show what is happening here.

Treasury Inflation Protection Securities ("TIPS") / Interest Payment Adjusts With Inflation

"TIPS" - "Treasury Inflation Protection Securities" have a fixed interest rate over the life of the bond; however, the principal amount is adjusted every 6 months by an amount equal to the change in the Consumer Price Index. The bond pays interest semi-annually, and the interest amount (the fixed rate x the adjusted principal amount) will increase if the principal amount is adjusted upwards due to inflation; and will decrease if the principal amount is decreased due to deflation.

Principal Only (PO)

A Principal Only (PO) security only pays out based on the principal payments made - so it pays smaller amounts in the early years and larger amounts in the later years. Because most payments are loaded into the later years, it sells at a deep discount and exhibits great price volatility.

TAC Is "Single Buffered" Against Prepayment Risk Only

A TAC can be visualized as a tranche that has 1 companion that only absorbs prepayment risk - there is no buffer tranche that absorbs extension risk. Therefore, both PACs and TACs provide "call protection" against prepayments during periods of falling interest rates. TACs do not offer the same degree of protection against "extension risk" as do PACs during periods of rising interest rates - hence their prices will be more volatile during such periods. Other types of CMO tranches can be created from the underlying mortgage cash flows.

Mortgage Characteristics

A mortgage is defined as a pledge of property to secure payment of a debt, typically real estate such as a house. Traditionally, most home mortgages have been structured similarly. These characteristics are: Fixed rate of interest over the term of the loan; Equal level payments are made monthly; The loan is self amortizing - each monthly payment combines a portion of principal repayment with the interest payment due; Standardized maturities - most fixed rate mortgages have a 30 year life, though 15 year mortgages are becoming more popular. The only items left to negotiate on the loan are the interest rate and the term. Traditionally, most home mortgages have 30-year terms, though 15-year mortgages are becoming more popular. Due to the "standardization" of home mortgages, these debts lend themselves to "securitization" - which means they can be transformed into securities.

Agency Accrued Interest 30 / 360

Accrued interest on agency issues is computed on a 30-day month / 360 day basis. Government and agency bonds never trade flat. If they default, a financial crisis of major proportions would occur.

U.S. Government Accrued Interest (Actual/Actual)

Accrued interest on government issues that make semi-annual interest payments (T-Notes and T-Bonds) is computed on an actual day month / actual day year basis, with interest accruing up to, but not including settlement.

Secondary Dealers

All other firms trading U.S. Government securities are termed "secondary" dealers. These firms buy and sell Treasuries in the market through the primary dealers and can also bid in the weekly auction. Most smaller banks and brokerage firms are "secondary" dealers.

CMOs Are Non-Exempt Issues

Also note that while the FNMA, GNMA, and FHLMC securities held in the trust are exempt securities under the Securities Acts; CMOs are non-exempt securities. CMOs are a form of unit investment trust, a registered investment company type that is not exempt from the Securities Acts. This means that each CMO must be registered with the SEC and sold with a prospectus.

IO Prices Move In The Same Direction As Market Interest Rates

An IO's price volatility works opposite to everything you have already learned! If market interest rates rise, prepayments speeds will decrease (extension risk) and the maturity will lengthen. Thus, the holder will be receiving interest for a greater period of time - so the price of the IO will rise as well. On the other hand, if market interest rates fall, prepayment speeds will increase (prepayment risk) and the maturity will shorten. Thus, the holder will be receiving interest for a shorter period of time - so the price of the IO will fall as well. To summarize about PO and IO price volatility: As market interest rates rise, PO prices fall; as market interest rates fall, PO prices rise. As market interest rates fall, IO prices fall; as market interest rates rise, IO prices rise.

Interest Only (IO)

An Interest Only (IO) security only pays out based on the interest payments made - so it pays larger amounts in the early years and smaller amounts in the later years. It sells at a discount. Because most payments are loaded into the early years, it exhibits lesser price volatility.

Extension Risk

Another risk is that if interest rates rise sharply, homeowners will not prepay their mortgages at the expected rate. Instead, they will hold on to their old low-rate mortgages.

Targeted Amortization Class

Another type of tranche is called a Targeted Amortization Class (TAC). This is a variant of a PAC. A PAC offers protection against both prepayment risk (prepayments go to the Companion class first) and extension risk (later than expected payments are applied to the PAC before payments are made to the Companion class.) From our prior picture, a PAC has 2 buffer tranches - one companion absorbs prepayment risk and 1 companion absorbs extension risk. A TAC bond protects against prepayment risk; but does not offer the same degree of protection against extension risk. A TAC bond is designed to pay a "target" amount of principal each month. If prepayments increase, they are made to the Companion class first. However, if prepayment rates slow, the TAC absorbs the available cash flow, and goes in arrears for the balance. Thus, the average life of the TAC is extended until the arrears is paid.

Callable Bonds / Non-Callable Bullet Bonds

Bonds: Traditional callable bonds issued with up to a 30 year maturity that pay interest semi-annually. These are fixed rate bonds, issued in $10,000 minimum face amounts. Also note that FHLB issues "so-called" bullet bonds. These are non-callable bonds. The term "bullet bond" comes from the fact that these non-callable bonds are identified in dealer offering listings with a "bullet" next to the listing, indicating a non-callable bond. (To finance this activity, FHLB issues Callable Bonds / Non-Callable Bullet Bonds)

Agency CMOs

CMOs are now created directly by Ginnie Mae, Fannie Mae and Freddie Mac, using their own mortgage-backed securities (MBSs) as the underlying collateral. These are called "Agency CMOs" and because the underlying MBSs are rated AAA, the CMOs created from them are also rated AAA. This has "cut out" broker-dealers as the middleman who create CMOs that exclusively use agency MBSs as the underlying collateral.

CMOs Quoted On A Yield Spread Basis To Treasuries

CMOs are quoted in 32nds, similar to Treasury issues. Very often, dealers quote CMOs on a "yield spread" basis - this means that the dealer quotes the CMO at the same yield as an equivalent maturity Treasury issue plus a spread. The amount of the spread depends on the liquidity of the CMO, the makeup of the pool, the coupon rate, etc. Typical spreads range from 50 to 100 basis points over Treasuries.

Fed Tightening

Conversely, when the Fed wishes to tighten credit, it will sell Treasury securities to the primary dealers, which removes cash from the dealers (most of whom are banks). This raises market interest rates, since banks have less cash to lend.

Agency Debt Highest Rating

Debt is also issued by agencies of the U.S. Government. Agency debt is not backed directly by the Government's promise to pay. Instead, there is an implicit promise on the part of the government to pay if the debt defaults. (One agency debt is directly backed by the government - Government National Mortgage Association.)

Discount Notes

Discount Notes: Short-Term Obligations of 1 year or less, sold at a discount from minimum $100,000 face amount, with $1,000 increments thereafter. Because these are an agency obligation, with no "direct" U.S. Government guarantee, they yield more than equivalent maturity T-Bills. (To finance this activity, FHLB issues Discount Notes)

$25,000 Minimum Mortgage Backed Pass Through Certificates

Each agency continuously buys mortgages from originating banks. This gives the bank fresh funds to lend out on new mortgages. Once a sufficient amount of mortgages have been purchased (say $1 billion - yes, this market deals in big numbers!), they are placed into a "pool." The agency divides the pool into $25,000 mortgage backed pass through certificates and sells them to investors. (The reason why these are sold in $25,000 minimums, as opposed to $1,000 or $5,000 minimums for most other bonds, is to make them unattractive to the small investor. MBSs have an unusual risk that small investors may not understand, prepayment risk, covered following).

Each Tranche Has An Expected Life

Each tranche is said to have an "expected life," so this pool of 30-year mortgages is transformed into 10 tranches with 10 different "expected lives." This can be visualized as:

Fannie Mae Is "Privatized"

Fannie Mae was formed in 1938 in the Great Depression as a government agency to buy mortgages from banks, providing the banks with fresh funds to make new mortgages. It was "spun off" by the Federal government in 1968 as a separate profit making corporation and was NYSE-listed. In the 1990s during the Clinton Administration, Fannie Mae was mandated to buy "subprime" mortgages to make housing affordable to lower income groups. Many of these loans turned out to be bad credits, and the enormous amount of these bad loans purchased through the years forced Fannie (and Freddie Mac, covered following) into bankruptcy in 2008.

Fannie Mae / Buys VA And FHA Guaranteed Mortgages / Buys Conventional Mortgages

Fannie Mae: Buys government guaranteed and insured mortgages (such as Veterans Administration "VA" insured and Federal Housing Administration "FHA" guaranteed mortgages) as well as conventional mortgages from banks. It derives its income from the spread between the rate at which it borrows funds from the public and the rate it earns on purchased mortgages. It earns fees, as well, for servicing pass through certificates.

Federal Farm Credit System

Farmers can obtain low rate financing through the Federal Farm Credit System. To provide funding to farmers, such as short-term loans for planting and harvest; intermediate term loans to buy equipment; and long term loans to buy land and buildings; the Federal Farm Credit Banks Funding Corporation issues the following securities: Discount Notes: Short-Term Obligations of 1 year or less, sold at a discount from minimum $5,000 face amount, with $1,000 increments thereafter. Because these are an agency obligation, with no "direct" U.S. Government guarantee, they yield more than equivalent maturity T-Bills. Designated Bonds: Traditional non-callable bonds that pay interest semi-annually issued in 2-10 year maturities. These are issued in $5,000 minimum face amounts, with $1,000 increments thereafter. Bonds: Traditional callable bonds issued with up to a 30 year maturity that pay interest semi-annually. These can either be fixed rate bonds, issued in $5,000 minimum face amounts, with $1,000 increments thereafter; or floating rate bonds issued in $100,000 minimum face amounts, with $1,000 increments thereafter. Retail Bonds: Designed for retail investors, these are similar to the Bonds offering listed above, but are available in minimum $1,000 denominations and they have a unique estate planning feature. These bonds have a "survivor's option" which allows the bond to be redeemed at par plus accrued interest upon death. Since estate taxes (if any) are due 9 months after death, these bonds can be redeemed and used to pay that death tax liability. Unlike Treasuries which are sold at auction, these agency obligations are offered by a selling group of dealers, mainly large commercial banks and brokerage firms. They are given the same rating as Treasuries (AAA from Moody's and Fitch's; AA from Standard and Poor's), due to the "implied" backing of the U.S. Government. However, they typically yield .25% more than equivalent maturity Treasuries, because they do not have a direct U.S. Government guarantee. Also note that these selling dealers quote agencies on a "yield spread basis" to equivalent maturity Treasuries. For example, if the 30 year Treasury Bond is yielding 4.50%, while the 30 year Federal Farm Credit Bond is yielding 4.75%, the dealer will quote the FFCB bond at "25 basis points over." The U.S. Government promotes home ownership through the activities of the: Federal Home Loan Banks (FHLB) Federal National Mortgage Association ("Fannie Mae") Government National Mortgage Association ("Ginnie Mae") Federal Home Loan Mortgage Corporation ("Freddie Mac")

Federal Home Loan Bank (FHLB)

Federal Home Loan Banks: FHLB was the first mortgage agency, created in 1932 in the Great Depression to provide funds to Savings and Loans so they could give homeowners mortgages. It loans funds to Savings and Loan institutions, with the main collateral for the loans being S & L mortgages.

Fixed Rate Mortgage

Fixed Rate Mortgages: With a fixed rate mortgage, the mortgagor pays a fixed monthly amount, with each payment being a combination of principal and interest. The early payments are mostly interest, with very little principal repayment. As the payments progress, the interest component shrinks and the principal repayment component increases. The final payments are mostly principal and very little interest. This is depicted below:

TIPS

For investors that wished to avoid purchasing power risk, the Treasury introduced TIPS.

STRIPS

For investors that wished to avoid reinvestment risk, the Treasury introduced Treasury STRIPS.

Federal Home Loan Mortgage Corp. (FHLMC) / "Freddie Mac" / Buys Conventional Mortgages Only

Freddie Mac: The "Federal Home Loan Mortgage Corporation" (FHLMC) was the final mortgage agency, created in 1970. It was listed as a stock company on the NYSE. Its purpose is to buy conventional mortgages that do not carry government insurance or a government guarantee. This contrasts with Ginnie Mae that only buys government guaranteed or insured mortgages; and Fannie Mae that can buy both government guaranteed and conventional mortgages. Just like these other agencies, Freddie Mac buys these conventional mortgages from banks and places them into mortgage pools, which are then securitized and sold to investors. And just like Fannie Mae, Freddie Mac was mandated to buy subprime mortgages in the mid-1990s, and the mass defaults on these loans led to its bankruptcy in 2008.

Ginnie Mae

Ginnie Mae: The "Government National Mortgage Association" was created in 1968 - the same year that Fannie Mae was spun off by the Federal government. It is the only housing agency that is directly owned and backed by the Federal government. It was created when the MBS was first beginning to be introduced to the marketplace. Because it was a new security at the time, it was believed that, to gain broad investor acceptance, having a government agency issue them with a direct government backing would create a robust market (which it did).

Ginnie Only Buys Government Insured Mortgages

In contrast to Fannie Mae (and Freddie Mac, covered next), Ginnie does not buy conventional mortgages. It only buys FHA, VA, and Farmer's Home Administration (FmHA) insured mortgages from banks and places them into mortgage pools, which are then securitized and sold to investors.

Agencies Are Quoted On A Yield Spread Basis To Equivalent Maturity Treasuries

Most agency securities are quoted by dealers on a yield spread basis against equivalent maturing Treasuries. For example, a dealer may quote a 10-year GNMA certificate at "25 basis points over the Treasury." If 10 year Treasury notes are yielding 5.00%, the dealer is pricing the GNMA to yield 5.25%. The typical "spread" over Treasuries is 25 - 50 basis points, though this can vary depending upon market conditions.

U.S. GOVERNMENT AGENCY OBLIGATIONS

Our government believes that certain aspects of American life are sacrosanct - Motherhood, Apple Pie, Farming, and Home Ownership. Government policy promotes these aspects of American life. U.S. Government agencies have been formed to finance the last two sacred cows.

Principal Only (PO) / Interest Only (IO)

POs and IOs are mortgage backed securities that are created by "breaking apart" the stream of interest payments from the principal repayments generated by the underlying collateral. These can be created directly from the mortgaged backed security or can be created in the form of CMO tranches.

Sallie Mae Is "Privatized"

Sallie Mae is another "privatized" company, whose stock is listed on NASDAQ - and it is not bankrupt! It makes its profit from the spread between the interest rate charged on its loans to students versus the lower interest rate at which it can borrow funds. Sallie Mae is much smaller than the housing agencies, with about $200 billion of debt outstanding.

Redeemable - Non-Negotiable

Savings bonds (Series EE) do not trade - they are issued by the Treasury and are redeemed with the Treasury (a bank can act as agent for the Treasury issuing and redeeming Series EE bonds). No physical certificates are issued - the bonds are issued in electronic form.

New Issues - Book Entry

Short-term Treasury Bills, intermediate-term notes and long-term bonds are typically issued in "book entry" form. No certificates are issued for book entry securities; the only ownership record is the "book" of owners kept by the transfer agent. No physical certificates have been issued since 1983. Prior to that date, notes and bonds were available in fully registered form - physical certificates were issued. These outstanding securities continue to trade until their redemption date.

Treasury Bills / Up To 12 Months / Yield Basis Quote

Short-term securities issued with 1, 3, 6 and 12 month maturities (this should be known as 4 weeks, 13 weeks, 26 weeks and 52 weeks as well). Treasury Bills are issued at a discount from par ($100 minimum) and mature at par. The discount earned is considered to be the interest income. They are quoted on a discount yield basis.

Pass-Through Problems

Some inherent problems with pass through certificates led to the next development in the mid 1980s - CMOs - Collateralized Mortgage Obligations. The inherent problems with pass through certificates are: Mortgage pools have a long fixed life. Most pools are either 30-year mortgages or 15-year mortgages. Investors are buying a security with a long life. This cuts out many investors looking for shorter term maturities.

Lower Interest Rate Than Regular Treasury Issues

TIPS have a lower interest rate than similar maturity regular Treasury issues because of this inflation protection feature. TIPS are only available for long-term Treasury issues. Over the past 20 years, as the inflation rate has dropped in the United States, nominal rates have fallen at a similar rate. However, the "real interest rate" on 30 year Treasury bonds has not changed at all - it has stayed right around 3%. What this chart implies is that nominal interest rates for Treasury bonds really have 2 components - the "real" interest rate of 3% plus that year's inflation rate. So, as inflation rates drop, nominal rates fall in tandem, and real rates stay the same. On the other hand, if inflation heats up again, then nominal rates will rise. This will hurt the holders of conventional long-term Treasury Bonds. With the addition of TIPS, the Treasury is really giving the investor a choice - you can buy a 3.50% conventional 30 year Treasury bond that is subject to interest rate risk; or you can buy a 3% TIPS, where each year, your return will be the 3% "real interest rate" plus an additional return equal to that year's inflation rate. So if inflation rises to, say, 1% in 2018, the TIPS return for that year will be the 3% real rate + the 1% inflation rate for that year = 4% total return. (The 3% is received as interest, while the inflation component is added to the principal amount of the bond.) If the inflation rate rises to 2% in 2019, then the TIPS return for that year will be the 3% real rate + the 2% inflation rate for that year = 5% total return. If the inflation rate rises again to 3% in 2020, then the TIPS return for that year will be the 3% real rate + the 3% inflation rate for that year = 6% total return. Thus, as inflation rises, the return rises, and the TIPS price will not fall.

PACs Are Safest

The PAC tranche is given the most certain repayment date by being buffered against prepayment risk and extension risk. Because it is being relieved of these risks, it is the safest tranche and is offered at a lower yield.

Predecessor To STRIPS Is A Treasury Receipt

The Treasury first started selling STRIPS in 1986. Before this, brokerage firms would buy conventional Treasury bonds and "strip" them to sell to pension fund investors. These broker-created zero-coupon bonds are generically called Treasury Receipts. They are no longer created (because the Treasury cut out the middleman by stripping bonds itself) but they still trade in the market. For the exam, Treasury Receipts must still be known - remember that they are zero-coupon Treasury bonds.

Discount On T-Bills Taxed As Interest Income In Year Received

The discount on short-term Treasury Bills and short-term "unprivatized" Agency Notes is taxed as interest income in the year the obligation matures. This interest is subject to federal income tax but is exempt from state and local tax.

Securitized Mortgage / Interest Rate On GNMA Certificate Typically 50 Basis Points Lower Than Mortgage Rate

The first "securitized" mortgages were the "pass through" certificates issued by GNMA. These originated in the late 1960s. GNMA purchased mortgages from lenders with the same interest rate (say 5%) and term, and assembled them into a pool. Undivided interests in the pool were then sold to investors as "securities" - in this case, GNMA pass through certificates (yielding, say 4.50%). The 50 basis point difference is the gross profit to GNMA, out of which selling and operating expenses are paid. Each payment received by a certificate holder represents a portion of the total mortgage payments received on the pool that month.

Government And "Unprivatized" Agency Debt Subject To Federal Tax And Is Exempt From State And Local Tax

The interest income from U.S. Government Notes and Bonds and "unprivatized" Agency debt making periodic interest payments is subject to federal income tax but is exempt from state and local income tax. This tax status derives from the fact that one level of government does not tax the other. Bonds and notes pay interest semi-annually, so two interest payments are included on each year's federal income tax return.

No Stated Maturity

The interest rate is set at the date of issuance. Interest is "earned" monthly and credited to the principal amount every 6 months. The bonds have no stated maturity - the holder can redeem at any time, however interest is only credited to the bonds for 30 years.

Primary Dealers

The largest participants in the market are the "primary" U.S. Government securities dealers. There are about 20 firms which are primary dealers (e.g. Goldman Sachs, Citigroup, Nomura Securities, J. P. Morgan Chase Bank, Royal Bank of Scotland). The Federal Reserve designates a dealer as primary after the firm demonstrates over many years its capacity to purchase Treasury securities at the weekly auction and to make an orderly trading market in these issues (that is, the dealer is able to resell them to the public). Primary dealers are hooked up to the "Federal Reserve" wire system and deal directly with the "Fed."

Prepayment Risk

The length of the certificate depends on the underlying mortgages in the pool. In reality, the actual life of the certificate is shorter because mortgage prepayments occur when homes are sold or mortgages refinanced. These prepayments are passed through to the certificate holder. Because of prepayment risk, the real maturity is unknown.

"Fannie," "Freddie," "Ginnie" / Issuers Of Mortgage-Backed Securities

The other 3 housing agencies - Fannie Mae, Freddie Mac and Ginnie Mae - are primarily the issuers of "mortgage-backed pass through certificates." They also issue other types of debt, but the vast majority of their debt issuance is in the form of "MBSs" - Mortgage Backed Securities. There is a huge amount of mortgage backed debt issued by these agencies - about $14 trillion as of the end of 2016 (as compared to $20 trillion of Treasury debt). Before going into the specifics of each agency, let's cover MBSs, because they are completely different from conventional bonds.

Floating Rate Tranches

These are CMO PAC, TAC or companion tranches that have interest rates that are tied to a recognized index, such as LIBOR (the London Interbank Offered Rate, which is the European equivalent to the Fed Funds rate). As LIBOR moves, the interest rate on the tranche moves the same direction, subject to a maximum rate cap and a minimum rate floor. As a variable rate security, market risk is minimized with these tranches.

Cash Management Bill (CMB) / 5 Days To 6 Months

These are very short-term Treasury securities with typical maturities that can range anywhere from 5 days to 6 months. Unlike other Treasury securities that are sold at a regular scheduled auction, these are sold at auction on an "as needed" basis when the Treasury is running low on cash. Thus, they are used by the Treasury to smooth out its cash flow needs. They are sold in $100 minimum amounts and pay a slightly higher interest rate than equivalent maturity T-Bills sold on a regular auction schedule.

CMOs Are A Derivative Security / Plain Vanilla CMO

This is an example of a "derivative" security - the value of each tranche is derived from the method used to allocate cash flows. Older CMOs of the type just illustrated are known as "plain vanilla" CMOs, because the repayment scheme is relatively simple - as payments are received from the underlying mortgages, interest is paid pro-rata to all tranches; but principal repayments are paid sequentially to the first, then second, then third tranche, etc. Thus, the earlier tranches are retired first.

PAC Is "Double Buffered" Against Both Prepayment And Extension Risk

Thus, the PAC class is given a more certain maturity date; while the Companion classes have a higher level of prepayment risk if interest rates fall; and a higher level of so-called "extension risk" - the risk that the maturity may be longer than expected, if interest rates rise.

Agency Debt Trading Less Active Than U.S. Governments

Trading of agency securities, once they are issued, is much less active than that for U.S. Government securities. Most agency issues are bought by institutions that hold them. For example, Ginnie Mae and Fannie Mae certificates are purchased by investment companies and sold to investors as mutual fund shares, since the $25,000 minimum per certificate is more than most people can handle. Dealers distribute quotes for agency securities through computer quotation systems.

Over-The-Counter Trading

Trading of government and agency securities takes place solely in the over-the-counter market. There is no trading on any exchange floor. The participants in the market include large commercial banks, foreign banks, U.S. Government securities dealers (firms that only handle government trades whose names are not household words, such as Cantor Fitzgerald), full service brokerage firms, as well as the Federal Reserve itself.

Treasury Bonds / 30 Year Maturity / Quoted In 32nds

Treasury Bonds: Long-term securities issued with maturities of 30 years. The bonds are issued in minimum denominations of $100 and pay interest semi-annually to registered holders. Note that the $100 minimum is atypical - corporate and municipal bonds are sold in $1,000 minimums. The Treasury reduced the minimum from $1,000 to $100 in 2008 to expand investor interest. For the exam, bond quotes will still be in $1,000 amounts. Treasury bonds are quoted as a percentage of par, in minimum increments of 1/32nd.

Treasury Note / Bond Quotations Treasury Note and Bond quotes are presented below:

Treasury Note and Bond quotes are presented below: The first column gives the interest rate. The second column gives the maturity. The symbols next to the maturity are: n-regular Treasury Note; no symbol-regular Treasury Bond. The third column gives the dealer's bid price. The dealer is willing to buy the Jan '19 notes at 99:24 which is 99 and 24/32nds = 99.75 = $997.50 per $1,000 par note. The dealer is willing to buy the May '34 bonds at 129:20 which is 129 and 20/32nds = 129.625 = $1,296.25. The fourth column is the dealer's ask price. The dealer is willing to sell the Jan '19 notes at 99:26 which is 99 and 26/32nds = 99.8125 = $998.125 per $1,000 par note. The dealer is willing to sell the May '34 bonds at 129:24 = 129 and 24/32nds = 129.75 = $1,297.50. Note that the bid price for the Jan '19 notes was 99:24; the ask price was 99:26. This means that the "spread" the dealer works on is 2/32nds per $1,000 par note equals $.625. This is small and reflects the highly competitive nature of this market. For every "round turn" trade (a buy and sell of this particular note), the dealer earns $.625. Narrow spreads are typical for active trading markets - and the government market is the most active in the world. The fifth column shows how much the bid has changed from the prior day. For the Jan '19 Note, the bid has dropped by 1/32nd. This indicates that interest rates have increased that day since the price has fallen. The sixth column shows the yield to maturity on the security. The Jan '19 4 1/4% note is priced to yield 5.43% to maturity. Since the note is priced at a discount, it makes sense that the YTM is higher than the nominal yield.

Treasury Bill Quotations

U.S. Government and agency obligations are quoted in the news media daily. Information on Treasury Bills is presented in the following format: The first and second columns give the maturity date of the Treasury Bill, with the number of days to maturity. Assuming that it is now December 7, 2017, the bill maturing Dec 8th has 1 day to maturity; Dec 15th has 8 days to maturity; Dec 22nd has 15 days to maturity, etc. The third column gives the discount yield that government dealers are willing to buy at that day (the "bid"). The dealer is willing to buy the bills dated December 22nd priced to yield 5.43%. This yield is a discount from par value. To actually find the dollar price of the T-Bill (assuming par is $1,000) and that it is now Dec 7, the approximate formula is: Dollar Price = $1,000 - $2.263 discount = $997.737 Bid Price *Note that, to make things even more confusing, the discount accrues on T-Bills on a 30/360 basis; as compared to an actual/actual basis for interest accrual on Treasury Notes and Bonds. However, this need not be known for the exam. Only the general "concept" must be understood. The fourth column gives the discount yield that government dealers are willing to sell at that day (the "ask"). The dealer is willing to sell the bills dated December 22 priced to yield 5.33%. This yield is a discount from par value. To actually find the dollar price of the T-Bill (assuming par is $1,000 and it is now Dec 7), the approximate formula is: Dollar Price = $1,000 - $2.221 discount = $997.779 Ask Price Please note that the bid price per $1,000 bill was $997.737; the ask price was $997.779. This indicates that the "spread" that the dealer works on is $.042 per $1,000. This is small and reflects the highly competitive nature of this market. For every "round turn" trade, (a buy and sell of this particular bill), the dealer earns 4.2 cents. Narrow spreads are typical for active trading markets - and the government market is the most active in the world. The fifth column shows how much the bid has changed from the prior day. For the Dec 22 T-Bill, the bid has increased by .05% - that is, 5 basis points. This shows that interest rates rose that day since the yield has increased. If the yield has increased, the discount is greater. Thus, the purchase price of the bill decreases. Remember, as interest rates rise, debt prices fall. The sixth column shows the yield an investor gets holding the T-Bill to maturity (yield to maturity). This is higher than the discount yield since YTM is a compounded yield. An investor can buy the Dec 22nd T-Bill at the dealer's asking price (here it is a discount yield of 5.33% = $997.779 price). However, the true yield to maturity is 5.42%.

Agency Debt Initially Offered By "Fiscal Agents"

When an issue is coming to market, the firms collect customers for the issue and receive a fee of about 1% for placing the issue. The firm may also buy part of the issue for its own inventory to resell at a later date. (Note: New issue procedures are covered in detail in the "New Issues" chapter).

Principal Repaid Faster Than "PSA"

When interest rates fall by a great deal, the mortgages in the pool are paid off much earlier than expected. These principal payments come in much faster than the "PSA" (Prepayment Speed Assumption) used when the pool was created and the shape of the repayment curve "shifts" to the left as shown following:

Fed Loosening

When the Fed wishes to loosen credit, it will buy Treasury securities from the primary dealers, which places cash into the dealers (most of whom are banks). This lowers market interest rates, since banks have more cash to lend.

Collateralized Debt Obligation (CDO)

Whereas a CMO holds underlying mortgages as collateral and then "slices and dices" the mortgage payments into cash flows to create different tranches for sale to investors, the CDO take this process to the next level. A CDO is a "special purpose entity" (SPE) that buys tranches of a CMO. CDO issuance exploded in 2006-2007 and they were indicted in the market crash of 2008-2009. CDOs would buy tranches of so-called "private label" CMOs which were created from sub-prime mortgages and not Fannie, Freddie or Ginnie backed (and therefore AAA rated) mortgages. The ratings agencies did not understand the riskiness of the underlying sub-prime mortgage tranches (now known as the "toxic waste of the securities industry") and gave these CDOs high ratings. When the housing market collapsed, so did the sub-prime mortgage market as defaults ballooned. Correspondingly, CDO prices collapsed as well. Since then, there has been almost no issuance of CDOs, but they must be known for the exam.