Fixed Income Securities Test 2
Consider a mortgage-backed security with an outstanding mortgage balance of $500,000,000 and a pool factor of 0.95 for Month 30. The outstanding mortgage balance for the loan pool for Month 30 is closest to?
$500m * .95 = $475m
3 reasons why a municipal issuer may refund an issue by creating an escrow fund.
- Creating an escrow fund to repay bond holders eliminates restrictive bond covenants (motivation behind escrow to maturity bonds) - Alter the maturity schedule of the obligation - when interest rates have declined after a municipal security has been issued, there is a tax arbitrage opportunity available to the issuer
What are the different types of agency pass-through securities?
- Government National Mortgage Association (Ginnie Mae) - Federal Home Loan Mortgage Corporation (Freddie Mae) - Federal National Mortgage Association (Fannie Mae).
Three parties to a letter-of-credit (LOC) agreement?
- LOC provider - Municipal issuer - Bond trustee
Treasury Note
- Pays a coupon - Issued at approximate to par - 2-10 years to maturity
Treasury Bond
- Pays a coupon - Issued at approximate to par - Greater than 10 years
Extension Risk
- The adverse consequence of rising mortgage rates. - When mortgage rates rise, the price of the pass-through will decline, but more so than an other bonds because the higher rates will tend to slow the prepayment rate. - When mortgage rates rise, investors would prefer that prepayments speed up so that they can reinvest the prepayments at the higher market interest rate.
Contraction risk
- Undesirable consequences of decline in mortgage rates. - Pass-through prices increase, but less than that of an option-free bond. - The cash flow associated with prepayments must be reinvested at a lower rate.
Agency MBS market includes
- agency mortgage pass-through securities - agency collateralized mortgage obligations or CMOs - agency stripped MBS
In evaluating general obligation bonds, the commercial rating companies assess information in what four basic categories?
- information on the issuer's debt structure to determine the overall debt burden - issuer's ability and political discipline to maintain sound budgetary policy - determining the specific local taxes and intergovernmental revenues available to the issuer - assessment of the issuer's overall socioeconomic environment (i.e. local employment distribution and composition)
Treasury Bill traits
- issued at a discount to par - no coupon payment - mature at par value - Current practice is for the treasury to issue them with a maturity of 1 year or less
Assume that an individual obtains a non-recourse mortgage loan for $500,000. One year later, when the outstanding balance of the mortgage is $490,000, she cannot make her mortgage payments and defaults on the loan. The lender forecloses and sells the house for $315,000. The amount the lender is entitled to claim from the borrower beyond the proceeds of the sale is closest to?
0
You are interested in buying a home worth $650,000. Your lender requires a 20% down payment on a 30-year loan at a 7.5% interest rate. Your monthly gross income is $12,000 and your back ratio is 26%. Your loan-to-value (LTV) at the time of loan origination will be closest to?
1 - down payment of 20% = 80%
Two types of tax risk to which tax-exempt municipal securities buyers are exposed.
1. Income tax rates will be reduced which reduces the benefit of the municipal bond's tax exempt status 2. If it losses its tax exempt status
Assuming the quoted price for a $100,000 par value treasury coupon is 104.037, the dollar price of this security is closest to?
104 + 3/32 + 7/256 = 104.12109 104.12109 * 1,000 = 104,121.09
As $100,000 par Treasury bond is quoted at a price of 112-18+. The price of this bond as a percent of its par value is closest to?
112 + 18/32 + 1/64 = 112 + .5625 + .015625 = 112.5781
Strategic default occurs at loan to value ratios around?
125%
CMO structure backed by 9% collateral Tranche A Par 400 Coupon Rate 6.75% Tranche B Par 350 Coupon Rate 7.00% Tranche C Par 300 Coupon Rate 7.25% Tranche D Par 350 Coupon Rate 7.50% The notional amount for a notional IO based on this structure is closest to?
294.444m
Explain how an inverse-floating-rate municipal bond can be created.
3 different ways 1. A municipal dealer can buy in the secondary market a fixed-rate municipal bond and place it in a trust. The trust then issues a floater and an inverse floater. 2. Municipal dealer uses a newly issued municipal bond to create a floater and an inverse floater. 3. Create an inverse floater without the need to create a floater. This is done using the municipal swaps.
Consider an inverse floating rate collateralize mortgage obligation (CMO) bond class with the following characteristics: Cap (K) = 30% Coupon leverage (L) = 2.5 Reference rate = 1-month LIBOR If 1-month LIBOR = 3.25% at the beginning of the month, the inverse floater coupon rate for the month is closest to:
30% - 2.5 * 3.25% = 21.88%
For the following adjustable rate mortgage, what are the terms? 4.25%, 5/1 2-2-5 ARM
4.25% starting interest rate 5 means it will be this rate for years 1-5 1 means that the rate can change once a year first 2 means the first adjusted rate cannot be greater than 2% second 2 means that the rate cannot change more than +/-2% from the previous year's rate 5 means the rate has a lifetime cap of 5%
Which of the following loan-to-value (LTV) ratios is viewed most favorably in the eyes of a residential mortgage lender? 85% 90% 75%
75%
Price of a bond quoted as: 96.14+
95 + 14/32 + 1/64 = 96.453125
Price of a bond quoted as: 96.141
96 + 14/32 + 1 / 256 = 96.44140625
Price of a bond quoted as: 96.142
96 + 14/32 + 2/256 = 96.4453125
Price of a bond quoted as: 96-14
96 + 14/32 = 96.4375
Price of a bond quoted as: 96.14
96 + 14/32 = 96.4375
What is a Build America Bond?
A BAB is a taxable municipal bond wherein the issuer is subsidized for the higher cost of issuing a taxable bond rather than a tax-exempt bond in the form of a payment from the U.S. Department of the Treasury. (These were allowed to provide assistance to financially distressed municipalities during the recession)
What is the role of a lockout in a CMO structure?
A CMO structure with no principal payments to a PAC bond class in the earlier years is referred to as a lockout structure. A lockout structure provides greater prepayment protection to all PAC bonds in the CMO structure.
What is a bullet bond?
A bullet bond cannot be redeemed prior to maturity.
In a revenue bond, what is a catastrophe call provision?
A catastrophe call provision that requires the issuer to call the entire issue if the facility is destroyed
For a Treasury auction what is meant by a competitive bidder?
A competitive bid specifies both the quantity sought and the yield at which the bidder is willing to purchase the auctioned security.
direct-pay LOC
A direct-pay LOC grants the trustee the right to request that the LOC provider provide principal and/or interest for the LOC-backed municipal bond if there is a specified event or default or an inability of the municipal issuer to meet a contractual interest payment or principal at the maturity date.
What is the difference between a fallen angel and an original-issue high-yield bond?
A fallen angel is a bond with the same low rating as an original-issue high-yield bond. However, unlike the original-issue high-yield bond, the fallen angel once had a higher bond rating before it was downgraded.
Prime Loan
A loan that is originated where the borrower is viewed to have a high credit quality
For a Treasury auction what is meant by a noncompetitive bidder?
A noncompetitive bidder is a bidder is who is willing to purchase the auctioned security at the yield that is determined by the auction process. They specify the amount sought but not the price. The quantity in a noncompetitive bid may not exceed $1 million for Treasury bills and $5 million for Treasury coupon securities.
Explain what is meant by a residential mortgage-backed security.
A security that is created when residential mortgages are packaged together to form a pool of mortgage loans and then one or more debt obligations are issued backed by the cash flow generated from the pool of mortgage loans.
What is a mortgage pass-through security?
A security that results when one or more mortgage holders form a collection (pool) of mortgages and sell shares or participation certificates in the pool. From the pass-through, two further derivative mortgage-backed securities are created: collateralized mortgage obligations and stripped mortgage-backed securities.
What is a syndicated bank loan?
A syndicated bank loan is one in which a group (or syndicate) of banks provides funds to the borrower.
What type of prepayment protection is afforded a TAC bond?
A targeted amortization class (TAC) bond has a schedule of principal repayment. A TAC bond has a single PSA rate from which the schedule of principal repayment is protected.
Notional Interest-Only (IO)
A tranche (bond class) that receives the excess coupon interest.
What type of prepayment protection is afforded a VADM?
Accrual or Z bonds have been used in CMO structures as support for bonds called very accurately determined maturity (VADM) or guaranteed final maturity bonds. In this case the interest accruing (i.e., not being paid out) on a Z bond is used to pay the interest and principal on a VADM bond. This effectively provides protection against extension risk even if prepayments slow down, because the interest accruing on the Z bond will be sufficient to pay off the scheduled principal and interest on the VADM bond. Thus the maximum final maturity can be determined with a high degree of certainty. If prepayments are high, resulting in the supporting Z bond being paid off faster, however, a VADM bond can shorten.
Which of the following most completely describes the types of risk associated with home loans? Credit Risk Prepayment Risk Liquidity Risk Price Risk
All are risks associated with home loans
In a Treasury auction, how is the price that a noncompetitive bidder must pay determined in a single-price auction format?
All bidders are awarded securities at the highest yield (or lowest price) of accepted competitive tenders
Event Risk
An announcement or some event there is an almost immediate credit rating downgrade for the adversely impacted corporation, sector, or industry.
Headline Risk
An announcement results in an adverse impact on the credit spread, as with event risk, but does not result in an immediate downgrade of debt
Investment grade bank loan
An investment-grade loan is a bank loan made to corporate borrowers that have an investment-grade rating.
The bond described below is selling for settlement on 16 June 2014 - Annual Coupon = 6% - Coupon payment frequency = 10 April and 10 October - Maturity date = 10 October 2016 - Day Count Convention = 30/360 - Annual yield to maturity = 4% The accrued interest per 100 of par value for Bond G on the settlement date of 16 June 2014 is closest to?
April 10 to June 16th = 66 days 6 / 360 = .01667 interest per day .01667 * 66 = $1.1 accrued interest per 100 dollars of par
When comparing US Treasury Bills with Treasury Notes and bonds, it is customary to express the T-bill at its?
Bond-equivalent yield
You are considering of one of two, 20-year 8% coupon bonds. Both bonds are identical in all respects except one bond is noncallable while the other is nonrefundable. Which of the following strategies is most appropriate if you believe that interest rates will decline over your investment horizon.
Buy the noncallable bond because it provides the most protection against early or unwanted redemption regardless of changes in interest rates.
Jayesh Rangan's gross monthly income is $8,500. His monthly mortgage payment is $1,281.50 and he has the additional monthly expenses presented below. • Property taxes - $489 • Home insurance - $135 • Car payment- $250 • Credit card - $300 Rangan's back ratio is closest to?
Back ratio = (1,281.50 + 489 + 135 + 250 + 300) / 8,500 = 28.89%
For a sinking fund, if only part of the total amount has been retired by the end of the term, the remainder is called a?
Balloon Maturity
The price of a treasury bill with 180 days to maturity and $1 million face value is 965,000. The bank discount basis yield for this security is closest to?
Bank Discount Yield = (Dollar Discount / Face Value) * (360 / t) Where Dollar Discount = Face Value - Price Bank Discount Yield = .035 * 360/180 = .07 or 7%
Formula for the Bank Discount Yield
Bank Discount Yield = Dollar Discount / Face Value * 360 / Days to Maturity Where Dollar Discount = Face Value - Price
Because PAC bonds have protection against both _________ risk and __________ risk, they are said to provide two-sided prepayment protection.
Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection.
Why is the yield ratio typically less than 1?
Because of the tax-exempt feature of municipal bonds, the yield on municipal bonds should be less than that on Treasuries with the same maturity.
Given that 100 PSA equals 6%, the conditional prepayment rate (CPR) and single monthly mortality rate (SMM) for the 25th month is?
Because t < or = 30, CPR = 6% * 25/30 * 100/100 = 5% SMM = 1 - ( 1 - CPR of 5%) ^ (1/12) = .4265%
What is meant by an issue or issuer being placed on a credit watch?
Being placed on a credit watch means the issue or issuer is under review for a possible change in rating.
Bond Equivalent yield =
Bond Equivalent Yield = Discount / Price * 365 / Days to Maturity
Explain why in a reverse PAC bond structure the longest average life bond can turn out to be effectively a support bond if all the support bonds in the structure are paid off.
By requiring the longer PAC bonds to receive any excess principal, these bonds are effectively performing the same function as the support bonds.
CD equivalent yield
CD equivalent yield = Dollar Discount / Price * Days to Maturity
Which of the following statements is false about CMOs? CMOs transfer various forms of prepayment risk among different classes of bondholders Agency CMOs are issued by the agencies that issue pass-through certificates CMOs eliminate all prepayment risk
CMOs eliminate all prepayment risk
What factor can be used as a proxy for cash-out refinancing incentives?
Cash-out refinancing is driven by price appreciation that has occurred since the origination of the loans in the pool. A proxy measure for price appreciation must be used. For the Bear Stearns agency prepayment model, the pool's HPI.
What is meant by prepayments due to cash-out refinancing?
Cash-out refinancing means refinancing by a borrower in order to monetize the price appreciation of the property.
What is the difference between a Chapter 7 and Chapter 11 bankruptcy filing?
Chapter 7 deals with the liquidation of a company; Chapter 11 deals with the reorganization of a company.
Which of the following statements relating to commercial paper is most accurate? - There is no active secondary market for trading commercial paper - Only the strongest, highly rated companies issue commercial paper - Commercial paper is a source of interim financing for long-term projects
Commercial paper is a source of interim financing for long-term projects
The main difference between conforming and non conforming loans?
Conforming loans meet the underwriting standards of Fannie Mae and Freddie Mac, whereas non conforming loans do not
For a mortgage pass-through security, which of the following risks is most likely to increase as interest rates decline? Contraction Risk Extension Risk Prepayment Risk
Contraction risk
What is a sinking fund requirement in a bond issue?
Corporate bond indentures may require the issuer to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement. This kind of provision for repayment of corporate debt may be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a part of the total by the end of the term.
Assume you purchased Treasury bond on November 14, with an annual coupon rate equal to 15%. At settlement you must pay accrued interest equal to $2.51. Assuming there are 182 days in a coupon period, how many days were in the AI period?
Coupon of 15% = $15 per $100 of par Coupon interest per day = 15 / 364 = .0412 $2.51 / .0412 = 61 days
What is meant by coupon stripping in the Treasury market?
Coupon stripping, in general, refers to detaching the coupons from a bond and trading the principal repayment and the coupon amounts separately, thereby creating zero coupon bonds.
Relative to agency residential mortgage backed securities (RMBS), which of the following is most important when investing in non-agency RMBS? Credit Risk Extension Risk Contraction Risk
Credit Risk
Dealer Placed Paper
Dealer-placed paper requires the services of an agent to sell an issuer's paper. The agent distributes the paper on a best efforts underwriting basis by commercial banks and securities houses.
Directly Placed Paper
Directly placed paper is sold by the issuing firm directly to investors without the help of an agent or an intermediary.
Suppose the default rate for a corporate security is 5% and, in the event of default, the average recovery rate is 30%. The expected loss if default occurs is closest to?
E (Loss) = Default probability * (1 - Recovery Rate) E(Loss) = .05 * (1-.3) = 3.5%
Which of the following statements is FALSE? - all coupon treasury security can be created STRIPs - Treasury STRIPs were created due to demand for long term zero coupon with no credit risk - Treasury strips are uniquely attractive to US investors due to their preferential tax treatment
False = Treasury strips are uniquely attractive to US investors due to their preferential tax treatment Their tax treatment is not preferred it is actually bad because you can be paying out tax even though you are not receiving cash flow
A borrower with which of the following loan balances is most likely to default on their mortgage? Equity = 50% and Loan Balance = 50% Equity = 49% and Loan Balance = 51% Equity = 51% and Loan Balance = 49%
Equity = 49% and Loan Balance = 51%
What is the significance of a secured position if the absolute priority rule is typically not followed in a reorganization?
Even though the absolute priority rule is not typically followed, it is still significant because senior claimants can use it to exercise clout in the reorganization process to insure they get the best possible deal.
High-yield bonds, commonly called junk bonds, are issues with quality ratings below triple B. A bond that was issued with a triple A rating, but has subsequently been downgraded to a C is most appropriately described as a?
Fallen Angel
Which term best describes a bond that was formerly an investment grade bond but is now classified as a high yield bond?
Fallen Angel
Explain why you agree or disagree with the following statement: "All municipal bonds are exempt from federal income taxes."
False, there are both taxable and non taxable municipal bonds
What is a government-sponsored enterprise?
Federal National Mortgage Association ("Fannie Mae"), the Federal Home Loan Mortgage Corporation ("Freddie Mac"), and the Federal Agricultural Mortgage Corporation ("Farmer Mac"). Federal Home Loan Banks and the Federal Farm Credit Banks.
Consider a $250,000, 25-year mortgage with monthly payments based on a 4.7% annual mortgage rate. The outstanding principal balance for this loan at the end of the 180th month is closest to?
First solve for payment N = 25 * 12 = 300 I/Y = 4.7 / 12 = .3917 PV = -250,000 FV = 0 PMT = ? = 1,418.11 Then Solve for the present value of remaining payments N = 300 - 180 = 120 I/Y = Same FV = Same PMT = Same PV = ? = 135,568.96
What is the difference between a liquidation and a reorganization?
First, In the case of a liquidation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. However, in the case of a reorganization, the absolute priority rule rarely holds. That is, an unsecured creditor may receive distributions for the entire amount of his or her claim and common stockholders may receive something, while a secured creditor may receive only a portion of its claim. The reason is that a reorganization requires approval of all the parties. Second, The liquidation of a corporation means that all the assets will be distributed to the holders of claims of the corporation and no corporate entity will survive. In a reorganization, a new corporate entity will result. Some holders of the claim of the bankrupt corporation will receive cash in exchange for their claims; others may receive new securities in the corporation that results from the reorganization; and still others may receive a combination of both cash and new securities in the resulting corporation.
In what ways does an MTN differ from a corporate bond?
First, corporate bonds generally have a longer maturity than a medium term note (MTN). Second, medium-term notes differ from corporate bonds in the manner in which they are distributed to investors when they are initially sold. (MTNs are typically distributed on a best effort basis) Third, MTNs are usually sold in relatively small amounts on a continuous or an intermittent basis. Fourth, on occasion, MTNs can offer advantages in terms of cost and flexibility.
How is interest income on TIPS treated at the federal income tax level?
For TIPS, the coupon payment is based on the inflation-adjusted principal. The U.S. government taxes the adjustment each year. This feature reduces the attractiveness of TIPS as investments in accounts of tax-paying entities.
Conforming limits
For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance
Ralph Singh has applied for a mortgage loan that will require monthly payments of $980. Mr. Singh's gross monthly income is $3,200 and he has the expenses in the bullet listed below: • Credit card debt payments = $670 per month • Car payment = $450 per month • Average utility payments = $300 per month. • Entertainment expenses = 480 per month • Expected homeowner insurance on new home = $1,200 per year • Expected property taxes on new home = $4,800 per year Ralph's front and back ratios are closest to:
Front Ratio = (980 + 100 + 400) / 3,200 = 46.25% Back Ratio = (980 + 100 + 400 + 670 + 450) / 3,200 = 81.25%
What are the common payment to income ratios?
Front Ratio and Back Ratio
Which type of mortgage is least likely to contain a balloon payment? Fully amortizing mortgage Partially amortizing mortgage Interest-only-Mortgage
Fully amortizing mortgage
Generally, the issuer may satisfy the sinking fund requirement by either
Generally, the issuer may satisfy the sinking fund requirement by either (i) making a cash payment of the face amount of the bonds to be retired to the corporate trustee, who then calls the bonds for redemption using a lottery, or (ii) delivering to the trustee bonds purchased in the open market that have a total face value equal to the amount that must be retired.
How does the guarantee for a Ginnie Mae mortgage-backed security differ from that of a mortgage-backed security issued by Fannie Mae and Freddie Mac?
Ginnie Mae MBS are backed by full faith and credit of the US government. For Fannie Mae and Freddie Mac, the MBS that they issue are not guaranteed by the full faith and credit of the U.S. government. Rather, the payments to investors in MBS are secured first by the cash flow from the underlying pool of loans and then by a corporate guarantee.
Although it is often stated that Ginnie Mae issues mortgage-backed securities, why is that technically incorrect?
Ginnie Mae provides the guarantee, but it is not the issuer.
What is a payment-in-kind bond?
Gives the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond. The period during which the issuer can make this choice varies from 5 to 10 years.
The Treasury does not actually offer securities with a coupon rate equal to the high yield because it adjusts the coupon rate and the price so that the yield offered on the security is equal to the?
High yield
What is meant by prepayments due to housing turnover?
Housing turnover means existing home sales. The two factors that impact existing home sales include (1) family relocation due to changes in employment and family status (e.g., change in family size, divorce), and (2) trade-up and trade-down activity attributable to changes in interest rates, income, and home prices.
Suppose that for the first four years of a CMO, prepayments are well within the initial PAC collar. What will happen to the effective upper collar?
If the prepayments are well within the initial PAC collar, this means that there are more bodyguards (i.e., support bonds) around than was expected when the PAC was structured at the initial collar. This will result in an increase in the upper range of the effective collar.
What of the following statements about US bankruptcy code is not true? - In chapter 7 bankruptcy, senior creditors are paid in full before junior creditors are paid anything - In chapter 7 bankruptcy stockholders are more likely to recover some the amount owned than creditors are to receive their investment - Chapter 11 bankrupt filings are more common than chapter 7 bankrupt filings
In chapter 7 bankruptcy stockholders are more likely to recover some the amount owned than creditors are to receive their investment
Conventional Loans
In contrast to government loans, there are loans that have no explicit guarantee from the federal government. Such loans are obtained from "conventional financing"
What is the typical flow of funds for a revenue bond in terms of the order of fund distribution?
In the order of: operation and maintenance fund, sinking fund, debt service reserve fund, renewal and replacement fund, reserve maintenance fund, and surplus fund
Assume that on Jan 1, you purchased a 10 year treasury inflation protected security (TIPS) with a 3% semiannual coupon, and a par value of $100,000. Then, after the first 6 months, the annualized inflation rate was 1.5%, your first coupon receipt will be closest to?
Inflation adjusted principal = 100,000 * 1.075 = 100,750 Inflation Adjusted Principal * semi annual rate = next coupon payment semi annual rate = 3% / 2 = 1.5% 100,750 * .015 = 1,511.25
Insured bonds are municipal issues that are secured by the issuer's revenue and backed by?
Insurance policies usually provided by monoline insurance companies
What is the federal income tax treatment of accrued interest income on stripped Treasury securities?
Interest income from Treasury securities is subject to federal income taxes but is exempt from state and local income taxes. A disadvantage of a taxable entity investing in stripped Treasury securities is that accrued interest is taxed each year even though interest is not paid.
How does sequential pay structure impact the average life of lower priority tranches?
It increases the average life because they are the last to receive their full distribution
Suppose a Treasury Bill with a face value of $100,000 is selling for $95,400 and is maturing in 125 days, A $100,000 CD with 125 days to maturity is trading at a 15% discount. Which of these securities has the lower price?
It is the CD because they tell you that the CD is trading at a 15% discount.
What does the "pass-through rate" of 5% mean?
It means the coupon rate is 5%
What happens to a TIPS principal payment if there is deflation?
It would still pay at the original par value because the Treasury has structured these instruments so that they are redeemed at at least par
Olympus Industries issued a $10M corporate bond that Moody's ranks as Ba1, S&P ranks as BB+, and Fitch ranks as a BB+ grade bond. This bond is commonly referred to as a?
Junk bond
rate-and-term refinancing or no-cash refinancing
Loan balance remains unchanged and the purpose of refinancing the loan is to either obtain a better note rate or change the term of the loan.
The ____________ ratio is the single most determinant for the likelihood of default
Loan to value ratio
Jumbo Loans
Loans larger than the conforming limit for a given property type
government loans
Loans that are backed by agencies of the federal government
two ways in which a bank can sell its position in syndicated loan.
Method of assignment Method of participation
Planned Amortization Class (PAC) bonds were created to?
Mitigate the uncertainty in cash flows due to prepayment risk
Explain why you agree or disagree with the following statement: "The debt of government-owned corporations is guaranteed by the full faith and credit of the U.S. government, but that is not the case for the debt of government-sponsored enterprises."
One would not agree with this statement because both government-owned corporations and also government-sponsored enterprises are not backed by the full faith and credit of the U.S. government.
Do you agree or disagree with the following statement? "Most MTN issues are rated non-investment grade at the time of offering."
One would tend to disagree given the nature of most MTNs. Because MTNs are issued with shorter maturity, ceteris paribus, they have less credit risk than long term bonds, which regularly achieve investment grade ratings.
From lowest to highest, the appropriate ranking of average life variability for collateral, support, and planned amortization class (PAC) bonds is?
PAC bond, collateral bond, support bond
TACs provide less protection than PACs bonds because?
PACs have a PSA range (collar) over which the schedule of principal repayment is protected against both contraction and extension risk.
Lenders prefer loan applicants with relatively low?
PTI and LTV ratios
Distinguish between a TBA and specified pool trade
Pass-throughs are quoted in the same manner as U.S. Treasury coupon securities. They are identified by a pool prefix and pool number. Many trades occur while a pool is still unspecified, and therefore no pool information is known at the time of the trade. This kind of trade is known as a "TBA" (to be announced) trade. The seller has the right in this case to deliver pass-throughs backed by pools that satisfy the PSA requirements for good delivery.
The management team at RJR Nabixo, led by Rex Jonestown, is planning a leveraged buyout (LBO) of the firm. Mr. Jonestown is proposing that the deal be financed with 30-year fixed rate coupon bonds. Nabixo's Treasurer agrees that long term debt is the optimal financing alternative but is concerned that during the first 5 years following the buyout, the newly formed company will be faced with significant cash flow constraints. He would therefore prefer flexibility with regard to the debt service demands on the firm's cash flow over the next 3-7 years. With this in mind, which of the following bond issues will be most appropriate for financing the LBO?
Payment in Kind bonds
conditional prepayment rate (CPR) is the?
Prepayment rate assumed for the pool
Collateralized Mortgage Obligations were created to mitigate:
Prepayment risk
Why would a pass-through with a WAM of 350 months be an unattractive investment for a savings and loan association?
Prepayment risk makes pass-through securities unattractive for certain financial institutions to hold from an asset-liability perspective. Thrifts and commercial banks want to lock in a spread over their cost of funds.
Sectors of the residential mortgage-backed securities market
Prime Sector includes (1) conforming loans and (2) non conforming loans that are still considered "Prime" but cannot be insured by the government agencies Sub Prime - loans to people with bad credit ratings or the loan is a second lien
What is the difference between a REMIC and a CMO?
REMIC means Real Estate Mortgage Investment Conduit and is a provision in the Tax Reform Act of 1986. This provision in the tax law allows the efficient creation of a CMO structure. Consequently, issuers, both agency and nonagency issuers, structure their CMO deals so as to qualify for REMIC tax treatment. Rather than referring to this multiclass mortgage structure as a CMO, the preference is to refer to it as a REMIC. Basically one that qualifies for REMIC is a CMO with preferential tax treatment
What is meant by prepayments due to rate/term refinancing?
Rate/term refinancing means that the borrower has obtained a new mortgage on the existing property to save either on interest cost or shortening the life of the mortgage with no increase in the monthly payment.
What is the difference between refunding protection and call protection?
Refunding protection prevents redemption only from certain sources, namely the proceeds of other debt issues sold at a lower cost of money. Call-protection prevents the company from recalling the bond at any time
Investors who would be most interested in investing in accrual bonds are those who are concerned with?
Reinvestment Risk
Carrollton is planning on building a new sports arena, what type of bond should they issue to fund the project?
Revenue bond
Suppose an investor owns a pass-through security for which the remaining mortgage balance at the beginning of a given month is $190 million. If the conditional prepayment rate (CPR) used to estimate prepayments is 6% and the scheduled principal payment is $3 million, the estimated prepayment for the month is closest to?
SMM = 1 - ( 1 - CPR of 6%) ^ (1/12) = .5143% prepayment for month t = .5143% * (190m - 3m) = 961,705
Can a bullet bond be redeemed prior to the stated maturity date?
Some bullet bonds are noncallable for the issue's life as the prospectus expressly prohibits redemption prior to maturity. Other issues carry limited call protection and can be called after a period of time.
What type of prepayment protection is afforded a reverse TAC bond?
Some institutional investors are interested in protection against extension risk but are willing to accept contraction risk. This is the opposite protection from that sought by the buyers of TAC bonds. The structures created to provide such protection are referred to as reverse TAC bonds.
What is an IO security?
Stripped MBS where all interest is allocated to this class (No principal)
What is a PO security?
Stripped MBS where all principal is allocated to this class (no interest)
Bullet Loans
Structures in which no repayment of the principal is made until the maturity date
TACs only protect against __________ risk, not ___________ risk
TACs only protect against contraction risk, not extension risk
Function of the CD equivalent yield
The CD equivalent yield (also called the money market equivalent yield ) makes the quoted yield on a Treasury bill more comparable to yield quotations on other money market instruments that pay interest on a 360-day basis.
Who determines the leverage of an inverse floater?
The Dealer
Suppose a $2 billion mortgage pass-through is used to create a collateralized mortgage obligation (CMO) with a planned amortization class (PAC) bond with a par value equal to $150 million and a support bond with a par value of $800 million. Which of the financial instruments will have the lowest average life variability?
The PAC bond
In a CMO structure with several PAC bonds, explain why, when the support bonds are paid off, the structure will be just like a sequential-pay CMO.
The PAC bonds and support bonds are formed from the sequential-pay CMO. If the support bonds are paid off earlier than expected, then the structure reverts to a sequential-pay CMO.
What is the S-curve for prepayments? Explain the reason for the shape.
The S-curve for prepayment is a graph where values for the "CPR%" are given along the vertical line and values for the "WAC/Mortgage Rate" ratio are found along the horizontal axis. The reason for the observed S-curve for prepayments is that as the rate ratio increases, the CPR (i.e., prepayment rate) increases. There is some level of the rate ratio, however, at which the prepayment rate tends to level off. The reason for this leveling of the prepayment rate is because the only borrowers remaining in the pool are those that cannot obtain refinancing or those who have other reasons why refinancing does not make sense.
The WI (When Issued) Market is part of the ____________ market and its transactions are settled only ___________
The WI (When Issued) Market is part of the secondary market and its transactions are settled only after they are issued
What is the principle of absolute priority?
The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything.
What is the advantage of a prepayment penalty mortgage from the perspective of the lender?
The advantage of a prepayment penalty mortgage from the perspective of the lender is that the lender can reduce losses if the borrower chooses to pay off the mortgage when rates fall.
What is the effect on the average lives of sequential-pay structures of including an accrual tranche in a CMO structure?
The average lives for the other tranches become shorter because of the inclusion of the accrual bond
The average life of a mortgage-backed security is?
The average time to receipt of principal payments (scheduled principal payments and projected prepayments), weighted by the amount of principal expected. Mathematically, the average life is expressed as follows:
Why does a properly structured prerefunded municipal bond have no credit risk?
The bonds are now supported by the portfolio of securities held in an escrow fund. Such bonds, if escrowed with securities guaranteed by the U.S. government, have little if any credit risk.
What is the burnout effect?
The burnout effect refers to the incentive to refinance being "extinguished." This occurs because the composition of borrowers in a mortgage pool changes over time due to seasoning and refinancing patterns. More specifically, as mortgage rates decline, those borrowers in the pool who are the most interest-rate sensitive prepay. The balance of the borrowers in the pool are less rate sensitive but as mortgage rates continue to decline, these borrowers prepay. As mortgage rates continue down, there is less additional prepayment activity and at some point, the incentive to refinance is "burned out."
Do you agree or disagree with the following statement? "Typically, a corporate issuer with an MTN program will post rates for every maturity range."
The company issuing MTNs may not desire to sell MTNs for various maturities. Thus, in their offering schedule, the company will not post rates for every maturity range.
TIPS inflation adjusted principal
The coupon payment and maturity value are based on the inflation adjusted principal
TIPS, what is the real rate?
The coupon rate
When-issued trading for both bills and coupon securities extends from the day the auction is announced until?
The day the auction is announced until the issue day
The bid and ask yields for a Treasury bill were quoted by a dealer as 5.91% and 5.89%, respectively. Shouldn't the bid yield be less than the ask yield, because the bid yield indicates how much the dealer is willing to pay and the ask yield is what the dealer is willing to sell the Treasury bill for?
The higher bid means a lower price. So the dealer is willing to pay less than would be paid for the lower ask price. This is how he makes his money
Which of the following statement regarding adjustable-rate mortgages (ARMs) is NOT TRUE. - The note rate on an adjustable rate mortgage changes over the life of the loan - The initial rate of an ARM is typically higher than fixed rates - ARMs have periodic rate caps that limit the amount that the interest rate may increase or decrease when it is adjusted
The initial rate of an ARM is typically higher than fixed rates This is false. The initial rates are going to be lower than fixed rates
accrual tranche or a Z bond
The interest for this tranche would accrue and be added to the principal balance.
All of the following conditions must be met for an investor to realize the yield based on a given PSA assumption, EXCEPT: -The investor must reinvest all the cash flows at the calculated yield - The investor must hold the pass-through security until at least 90% of the mortgages have been paid off - The assumed prepayment rate must actually occur over the life of the pass through
The investor must hold the pass-through security until at least 90% of the mortgages have been paid off
What derivative instrument is commonly used in creating a structured MTN?
The most common derivative instrument used in creating structured notes is a swap.
All of the following statements are accurate regarding medium term notes (MTNs) EXCEPT? - The most commonly used derivative when creating MTNs is the US Treasury Bond Futures contract - the all-in-cost funds for MTNs is often less than that of issuing bonds - MTNs are usually sold in relatively small amounts on a continuous or an intermittent basis
The most commonly used derivative when creating MTNs is the US Treasury Bond Futures contract
What was the motivation for the creation of PAC bonds?
The motivation for the creation of PAC bonds was to diminish the uncertainty in cash flows including prepayment risk.
Why is the pool number for a mortgage pass through important?
The pool number is important because it indicates the specific mortgages underlying the pass-through and the issuer of the pass-through.
What is the purpose of the daily index ratio?
The purpose of the daily index ratio is to help compute an inflation-adjusted principal for a settlement date. The inflation-adjusted principal is defined in terms of an index ratio, which is the ratio of the reference CPI for the settlement date to the reference CPI for the issue date.
What is a rating transition matrix?
The rating agencies accumulate statistics on how ratings change over various periods of time. A table that specifies this information is called a rating transition matrix.
What type of property is security for a residential mortgage loan?
The real estate. For residential mortgage loans this includes houses, condominiums, cooperatives, and apartments
sequential-pay CMOs
structured so that each class (or tranche) of bond would be retired sequentially
Why is a stripped Treasury security identified by whether it is created from the coupon or the principal?
The reason why a distinction is made between coupon strips and principal strips has to do with the tax treatment by non-U.S. entities where some foreign buyers have a preference for principal strips. This preference is due to the tax treatment of the interest in their home country.
If Congress changes the tax law so as to increase marginal tax rates, what will happen to the price of municipal bonds?
The required yield will go down and the price will go up
Describe how the schedule for a PAC tranche is created.
The schedule for a PAC tranche is set so that there will be greater predictability of the cash flow through establishing a principal repayment schedule that must be satisfied. The schedule will be set so that PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC classes, called support or companion bonds. It is these bonds that absorb the prepayment risk.
All of the following statements about agency mortgage pass-through securities is accurate EXCEPT: - The securitized mortgages of the loan pool have the same note rate and average maturity as the pass through security - Due to prepayments, the pass-through cash flow is uncertain - The monthly cash flow (pass through coupon rate) is less than the monthly cash flow of the loan pool by an amount equal to servicing and other fees
The securitized mortgages of the loan pool have the same note rate and average maturity as the pass through security
Explain the role of a support bond in a CMO structure.
The support bond class in a CMO structure provides for the prepayment protection for the other bond classes. It is the support bonds that forego principal payments if the collateral prepayments are slow. Support bonds do not receive any principal until the PAC bonds receive the scheduled principal repayment.
What is a debtor in possession?
The term "a debtor in possession" refers to the company filing for protection while continuing to carry on business. This gives a corporation time to decide whether to reorganize or liquidate and then the necessary time to formulate a plan to accomplish either a reorganization or liquidation.
What are the limitations of cash flow yield measures for a mortgage pass-through security?
The yield corresponding to a price must be qualified by an assumption concerning prepayments. Although yields are frequently quoted, remember that the yield is based on some underlying prepayment assumption.
What is the cash flow yield of a mortgage pass-through security?
The yield is the interest rate that will make the present value of the expected cash flow equal to the price
Why has there been a decline in corporate bond liquidity?
There has been a decline in corporate bond liquidity because traditional liquidity providers (such as dealers and banks) have pulled back due to risk aversion and the increase in regulations since the 2007 financial crisis that together make this business less attractive.
alternative-A loan
These loans are considered to be prime loans in regards to credit quality but they have some attributes that either increase their perceived credit riskiness or cause them to be difficult to categorize and evaluate.
Syndicated bank loans are called senior bank loans because?
They have priority position over subordinated lenders (bondholders) with respect to repayment of interest and principal.
Why do government dealers use government brokers?
They use interdealer brokers because of the speed and efficiency with which trades can be accomplished.
Why are prepayments attributable to cash-out refinancing likely to be insensitive to changes in mortgage rates?
This is because housing turnover is driven largely by family relocation due to changes in employment and family status as well as changes in income and the housing market. None of these factors are necessarily related to the level of mortgage rates.
For a Treasury auction what is meant by the high yield?
This is the highest yield (or lowest bond price) at which the treasury is willing to sell the issue
extendable reset bond
This structure allows the issuer to reset the coupon rate so that the bond will trade at a predetermined price. The coupon rate may reset annually or even more frequently, or reset only one time over the life of the bond. Generally, the coupon rate at reset time will be the average of rates suggested by two investment banking firms. The new rate will then reflect both the level of interest rates at the reset date, and the credit spread the market wants on the issue at the reset date.
Tier 1 commercial paper
Tier-1 paper is defined as eligible paper that is rated "1" by at least two of the rating agencies
Tier 2 commercial paper
Tier-2 paper security is defined as eligible paper that is not a tier-1 security
What can a municipality not issue a bond for?
To exploit the arbitrage that may exist due to the difference between higher treasury rates and the lower interest rates municipal issuers pay their existing bondholders
What is the when-issued market?
Treasury securities are traded prior to the time they are issued by the Treasury. This component of the Treasury secondary market is called the when-issued market
True or false Operations of the enterprise have priority over the servicing of the issue's debt, and cash needed to operate the enterprise is deposited from the revenue fund into the operation and maintenance fund.
True
What are the two categories of benchmark indexes used in adjustable-rate mortgages?
Two categories of reference rates have been used in adjustable-rate mortgages (ARMs): (1) market-determined rates and (2) calculated rates based on the cost of funds for thrifts.
A weighted-average coupon rate (WAC) is found by?
Weighting the mortgage rate of each mortgage loan in the pool by the amount of the mortgage outstanding
A weighted average maturity (WAM) is found by?
Weighting the remaining number of months to maturity for each mortgage loan in the pool by the amount of the mortgage outstanding.
When a prepayment is made that is less than the full amount to completely pay off the loan, what happens to future monthly mortgage payments for a fixed-rate mortgage loan?
When a curtailment is made, the loan is not recast. Instead, the borrower continues to make the same monthly mortgage payment and the principal is reduced
What delivery options are granted to the seller in a TBA trade?
When an investor purchases, say, $1 million GNMA 8s on a TBA basis, the investor can receive up to three pools, with pool numbers being announced shortly before the settlement date. Three pools can be delivered because the PSA has established guidelines for standards of delivery and settlement of mortgage-backed securities, under which TBA trade permits three possible pools to be delivered.
What are the limitations of using the equivalent taxable yield as a measure of relative value of a tax-exempt bond versus a taxable bond?
When computing the equivalent taxable yield, the traditionally computed yield to maturity is not the tax-exempt yield if the issue is selling at a discount because only the coupon interest is exempt from federal income taxes.
cash-out-refinancing
When the loan amount requested exceeds the original loan amount
What is meant by a make-whole call provision?
With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. T Note: Because the spread is small relative to the market spread at issuance, the bondholder is highly likely to benefit when the issuer invokes this option.
Why is a make-whole call provision probably a misnomer?
With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. The specified spread which is fixed over the bond's life is called the make-whole premium. Because the spread is small relative to the market spread at issuance, the bondholder is highly likely to benefit when the issuer invokes this option. Thus, the term "make-whole" misrepresents this provision and is probably a misnomer. It is highly likely that when the issuer invokes the option the bondholder will be made more than whole to compensate for the issuer's action.
What is the make-whole premium?
With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. The specified spread which is fixed over the bond's life.
How does a make-whole call provision differ from a traditional call provision?
With a traditional call provision, the call price is fixed and is either par or a premium over par based on the call date. With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield.
Yield ratio = ?
Yield ratio = yield on municipal bond / yield on same maturity treasury bond
Why is a default rate not a good sole indicator of the potential performance of a portfolio of high-yield corporate bonds?
You would also want to know the recovery rate
Suppose that a savings and loan association has decided to invest in mortgage-backed securities and is considering the following two securities: (i) a Freddie Mac pass-through security with a WAM of 340 months or (ii) a PAC tranche of a Freddie Mac CMO issue with an average life of two years. Which mortgage-backed security would probably be better from an asset/liability perspective?
a PAC tranche of a Freddie Mac CMO issue with an average life of two years
What is an FHA insured loan? The Federal Housing Administration (FHA) is an agency under the U.S. Department of Housing and Urban Development (HUD). FHA loans are guaranteed by the U.S. Government.
a government loan backed by an agency of the federal government
double barreled bond
a municipal bond issue secured by both enterprise revenue and the taxing authority of the municipal issuer
Agency loans satisfy the underwriting standards of?
agency loans satisfy the underwriting standard of the agencies used to create residential mortgage-backed securities
An agency collateralized mortgage obligation (CMO) and an agency stripped MBS are derivatives because they derive their value from
agency mortgage pass-through securities
Prefunded bonds
are refunded bonds with an escrow fund that is structured to retire the refunded bonds on the first possible call date.
Which of the following municipal debt issues carries the least amount of risk? - unlimited GOBs - Double Barreled GOBs - Bond issues backed by public credit enhancement programs
bond issues backed by public enhancement programs
Escrowed to Maturity Bonds
bonds are refunded bonds that have an escrow pool that is structured to support the bonds until the original maturity.
Fannie Mae and Freddie Mac can buy any types of loans but only _______________ loans for securitization purposes.
conventional
the purpose of the sinking fund provision is to reduce
credit risk
The cities of Dallas and Fort Worth are considering a joint venture to create a new super highway system to connect their downtown areas. The development and construction of the new highway will be financed using the proceeds from a bond issue. Upon completion, the new highway will be a toll road, whereby the tolls will be used to pay interest on the original bond issue. This is an example of:
dedicated revenue bond
Collateralized mortgage obligations derive their cash flow from underlying mortgage collateral such as pass-throughs or a pool of whole loans. Thus, CMOs can be referred to as a
derivative mortgage-backed securities product
Do you agree or disagree with the following statement: "All municipal bonds are exempt from state and local taxes."
disagree
In a single-price auction, all bidders are awarded securities at the highest yield of accepted competitive tenders (i.e., the high yield). This type of auction is called a?
dutch auction
There are two unique risks that can change corporate credit spreads:
event risk and headline risk
standby LOC and a confirming LOC require the trustee to?
first request any contractual payment from the municipal issuer before drawing down on the LOC.
Relative to an otherwise similar option-free bond, putable bonds will trade at a __________ price to an unputable bond
higher
Although a conventional loan may not be insured when it is originated, a loan may qualify to be insured when
it is included in a pool of mortgage loans that backs a mortgage-backed security (MBS).
Strongest type of support available from a commercial bank for a bond?
letter-of-credit (LOC) agreement
Which of the two types of bank loans is typically sold and traded in the secondary market?
leverage bank loans
Leveraged Bank Loan
leveraged loan is a bank loan to a corporation that has a below-investment-grade rating.
prepayment in which the entire mortgage balance is not paid off is called a
partial payment or curtailment
What are the two primary factors in determining whether or not funds will be lent to an applicant for a residential mortgage loan?
payment-to-income (PTI) ratio and the loan-to-value (LTV) ratio.
Which of the following is considered the safest municipal bond investment available? - prefunded municipal bonds - insured municipal bonds - Revenue bonds
prefunded municipal bonds
Support bonds provide?
prepayment protection for PAC tranches
Do you agree or disagree with the following statement? "Since Rule 144A became effective, all privately placed issues can be bought and sold in the market."
private-placement market can be divided into two sectors. First is the traditional private-placement market, which includes non-144A securities. For this market privately placed issues cannot be bought and sold in the market among qualified institutional buyers. Second is the market for 144A securities. For this market privately placed issues can be bought and sold in the market among qualified institutional buyers.
A CMO structure requiring any excess principal payments to be made to the longer PAC bonds after all support bonds are paid off is called a
reverse PAC structure
Private-label mortgage backed securities
securitized mortgages that do not conform to the criteria set by the Government Sponsored Enterprises Freddie Mac, Fannie Mae and Ginnie Mae.
A loan that is originated with a borrower who has less than investment grade credit and the or the loan is not a first lien on the mortgaged property is classified as a:
subprime loan
Bidding case for a competitive bidder: Suppose that $4 billion was tendered for at the high yield but only $3 billion remains to be allocated after allocating to all bidders who bid lower than the high yield. Then each bidder who bid the high yield will receive? So, if an entity tendered for $5 million, then that entity would be awarded?
suppose that $4 billion was tendered for at the high yield but only $3 billion remains to be allocated after allocating to all bidders who bid lower than the high yield. Then each bidder who bid the high yield will receive $3 billion / $4 billion = 0.75 = 75% of the amount for which they tendered. So, if an entity tendered for $5 million, then that entity would be awarded only 0.75($5 million) = $3.75 million.
Which of letter-of-credit bond provides the greatest protection for investors?
the direct-pay LOC
Two ways in which a bank can sell its position in syndicated loan Method of assignment
the holder of a loan who wants to sell its position can do so by passing on or assigning its interest in the loan
The issuance of municipal securities is regulated by?
the issuer's state government
In general, housing turnover is insensitive to?
the level of mortgage rates
GOBs are supported by?
the municipalities taxing authority
Two ways in which a bank can sell its position in syndicated loan Participation of assignment
the owner of a loan "participates out" a portion of its holdings. The holder of the participation does not become a party to the loan agreement and has a relationship not with the borrower but with the seller of the participation.
Price risk
the price of a fixed-income instrument will move in an opposite direction from market interest rates
Revenue bonds are supported by?
the revenue generated from the project the bond was used to finance
To estimate monthly prepayments, the CPR must be converted into a monthly prepayment rate, commonly referred to as?
the single-monthly mortality rate (SMM)
Which has the greatest average life variability in a CMO structure? The PAC bond class The collateral The support bond class
the support bond class
The principal pay-down window for a tranche is?
the time period between the beginning and the ending of the principal payments to that tranche.
CMOs are "customized securities" in the sense that?
they can be tailor-made to satisfy the preferences of investors
What is the reference rate typically used for a syndicated bank loan?
typically LIBOR plus a spread
Both Fannie Mae and Freddie Mac report the weighted average of the number of months since the origination of the security for the loans in the pool. This measure is called the?
weighted average loan age (WALA).
After origination of the MBS, the WAM of a pool changes. Fannie Mae and Freddie Mac report the remaining number of months to maturity for a loan pool, which they refer to as?
weighted average remaining maturity (WARM)
Refunded bonds
were originally issued as GOBs or revenue bonds and subsequently escrowed or collateralized with U.S. Treasury securities. The escrow fund is structured such that its cash flows match the obligations of the refunded issue.
