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What is a fixed income security?
A debt security represents a loan by an investor to an issuer. In return for the loan, the issuer promises to repay the principal of the debt on a specified date in the future and to pay the investor interest on the amount borrowed. Because the interest is paid at a fixed rate and at regular intervals, bonds or debt securities are also called fixed income securities. Fixed income securities are issued and can be redeemed by investors at par and interest (coupon) is paid semi-annually.
Mortgage Backed Securities (MBS)
Mortgage bonds are backed by the mortgage on a particular piece of property, with a first mortgage bond backed by the first mortgage, second mortgage bond backed by the second mortgage, and a general mortgage bond backed by either the third or some other mortgage on the same property. In the event of a claim on a mortgage bond, the first claim on the pledged property goes to the first mortgage, second claim on the second mortgage, and so on.
Mortgage bonds are considered relatively safe investments. In reorganization or liquidation, mortgage bonds have absolute priority among claims on assets pledged to secure them. They are sometimes referred to as senior debt securities. While mortgage bonds are considered relatively safe, individual bonds are ranked against other bonds and given high or low ratings by one of the various bond-rating organizations.
Collateralized Mortgage Obligations (CMO's)
A collateralized mortgage obligation (CMO) is represented by a pooling of a large number of mortgages, usually on single-family residences. These mortgages, and the principal and interest payments due to them, are the collateral behind the CMO. The pool of mortgages is then structured by the issuer into maturity classes called tranches. Tranches are set up to pay different rates of interest depending upon their maturity. Interest and principal are usually paid monthly. CMOs are issued by private sector financing corporations and by government sponsored entities (GSE's) such as FNMA and FHLMC and carry a AAA bond rating.
CMOs are similar to straight pass-thru certificates of GNMA and FNMA in that they pass through the income they receive to the investor. The income consists of regular payments of principal and interest from the mortgagers, as well as, the repayment of principal resulting from refinancing or other early payoffs.
The yield and maturity of a CMO are not guaranteed. The particular tranche an investor owns determines the schedule and security of her receipt of principal repayment. Investor's in CMOs need to understand that neither time to maturity, amount of interest received, nor amount of principal returned, is guaranteed.
The average maturity and rate of return of principal are estimated from historical data or projections of mortgage prepayments. The Public Securities Association (PSA) sets the standard model of prepayment speeds. The PSA prepayment model specifies an assumed monthly rate of prepayment of new mortgage loans. The prepayment assumptions on which CMOs maturity and rate of return are based are expressed as a multiple of the PSA prepayment rates. For example, an issue based on 150 PSA assumes the prepayments for the mortgages underlying the CMO will be 150 percent of the PSA prepayment rate.
Classes of Collateralized Mortgage Obligations (CMOs)
Among the many types of collateralized mortgage obligations (CMOs) that have been issued, floating rate bonds, accruals, PAC's, and TAC's are those typically invested in by credit unions.
A floating-rate tranche is a security that carries a variable interest rate tied to some index such as LIBOR, or the London Interbank Offering Rate. In England's eurodollar market, this is the interest rate banks charge each other on short-term money. This tranche will usually have a cap on the coupon rate and sometimes a floor. Interest and prepayment rates also affect their performance. (example)
An accrual bond (or Z tranche) is similar to a zero coupon bond. Holders of a Z tranche receive no cash payments for much of the life of the security, but the security increases in value as interest is accrued (though not received). Z tranche holders receive payments that are composed of both principal and interest, but only do so after all other tranches are retired. (example)
Planned amortization class (or PAC) bonds have established (planned) maturity dates; they are retired first and can offer protection from prepayment and extension risk because changes in prepayment speed are transferred to companion tranches (or support tranches). Planned amortization class bonds fit most credit unions investment risk profile. (example)
Targeted amortization class CMOs (or TAC's) have targeted maturity dates. A TAC structure transfers prepayment risk only to companion tranches and does not offer protection from extension risk (the chance that principal prepayments will be slower than expected). TAC investors accept the extension risk in exchange for a slightly higher interest rate. (example)
Characteristics of Collateralized Mortgage Obligations
Yields-CMOs typically yield more than Treasury securities. As with an ordinary bond, the length of maturity is related to the level of yield. Normally, payments are made to investors monthly.
Taxation. CMOs are fully taxable by federal and state governments. Because CMOs do not offer the tax advantage of Treasury securities, they typically return a higher rate of interest.
Liquidity. There is a secondary market for CMO's; thus they are considered liquid. However, there may be less of a market for certain CMO's (such as riskier or more complex tranches), and the investor may find that costs of trading CMO's are high. CMO's may trade at a premium or a discount from face value.
Safety. Because CMO's are backed by mortgages, they are relatively safe investments. However, investors in CMO's often don't fully understand the risks that do exist. Because of their susceptibility to interest rate changes in the rate of mortgage refinancing, CMO's carry several types of risk including:
- The rate of receipt of principal may vary
- If interest rates fall and homeowner refinancing increases, principal will be received sooner than anticipated and the investor may have to reinvest his principal at a lower interest rate (reinvestment risk).
- If interest rates rise and refinancing falls off, the CMO investor may have to hold his investment longer than anticipated (extension risk-the chance that the certificate will not mature before the stated date).
Certain tranches of a given CMO may be riskier than others. Some CMO's or certain tranches carry risk that principal or repayment of principal may take longer than anticipated.
Suitability. Different types of CMO's are especially unsuitable for smaller or less sophisticated investors because of their risks, which such investors may not fully understand. Refer to NCUA guidelines reported in Part 703 to assist in determining suitability for your credit union or contact your investment representative.
Evaluating debt securities
The most common way investors evaluate debt securities is by comparing their yields. Interest rate, time to maturity, price at purchase or sale, and call features all affect the investors yield. To ensure consistency, investors need to make sure they are comparing yields calculated by the same method as bonds are frequently quoted and traded by their yields rather than by dollar amounts.
Nominal yield, current yield, and yield to maturity are the most common methods of computing yields on fixed income securities.
Nominal yield
A bonds nominal yield (or coupon rate) is the percentage of a fixed-income security's par value to its annual payout. It is set at issuance and printed on the face of the bond. For example, a $100,000 bond with a 7% coupon means the issuer will pay $7000 interest every year until the bond matures.
Current yield
Current yield is the annual interest on a bond divided by the market value. It is the actual income rate of return as opposed to the coupon rate expressed as a percentage.
annual interest/market value=current yield
A bond traded at par will have identical nominal and current yields. A bond purchased at a discount will have a current yield higher than it's nominal yield and a bond purchased at a premium will have a current yield that is lower than it's nominal yield.
Although current yield accounts for the dollars actually invested in the bond, it does not take into account a gain or loss in the sale of the bond or whether it's held to maturity.
YTM
Yield to maturity is the percentage rate of return on a bond, note, or other fixed-income security if you buy and hold it to its maturity date. The calculation for YTM is based on the coupon rate, length of time to maturity, and market price. It assumes the coupon interest paid over the life of the bond will be reinvested at the same rate.
For example, if a 10% coupon bond is purchased at a premium (103 or $1030 per bond), you can expect to earn $100 in interest per year. If you hold the bond to maturity, you will amortize the $30 premium over the term of your investment. The premium should be accounted for when calculating the actual yearly earnings. (amortizing).
The YTM on a premium bond will always be lower than the nominal yield.
annual interest+prorated discount =annual ROI-prorated premium
purchase price+par value=YTM
Two bonds with the same current yield can have different YTM's. This is because the investor with the longer-term bond has to wait longer to realize the value of the discount. Prorating a $100 discount over 10 years is the equivalent of an additional $10 per year in income. Prorating the same $100 discount over 2 years means and additional income of $50 per year.
The YTM of discount bonds is typically higher than the coupon rate and the investor will accrete the discount until the bond is redeemed at par. For example, if an investor purchases a bond with a 10% coupon at a discounted price of 97 ($970 per $1000 face), she will receive $100 a year in interest. In addition, the investor realizes income of $30 ($1000-$970) if the bond is held to maturity. The discounted price helps bring the bonds yield back into line with the yields of newly issued bonds at higher coupon rates. Yield-to-maturity will differ from current yield whenever the price paid for the security differs from its par value. Accretion should be used to calculate actual yearly earnings of a bond bought at a discount (accretion).
A bond may be called any time after a call date set at the time of issuance (the time period before that is call protection). If a bond is called early, any discount will accrete faster (resulting in a higher yield) or any premium will be amortized over a shorter period (resulting in a lower yield). If the bond is callable at a premium, the amount to be prorated is the difference between the price paid and the call price (par plus premium).
Unless the bond issuer is paying a call premium, the yield of a bond bought at par and called away before its maturity date will remain unchanged. An investor who buys a 6% bond for $1000 receives a 6% return on the bond for however long it is held. The fact is not changed when the issuer calls the bond and repays the $1000 original investment.
On the other hand, an investor who buys a callable bond at a premium stands to lose income faster if the bond is called at par before its maturity date. One of the reasons the bonds price is at a premium to par (higher YTC/M) is that coupon rates on newly issued bonds are lower; thus, the sooner the bonds are called away, the sooner the premium the investor paid is recognized. Less of the premium paid in the secondary market will be recovered by the higher coupon rate received, thus the YTC will be lower then the nominal yield, current yield, or YTM if the bond is called at par.
YTC
Yield to call is the percentage rate of a bond or note if you were to buy and hold the security until the next call date. This yield is valid only if the security is called prior to maturity. Generally, bonds are callable over several years and normally are called at par. The calculation of yield to call is based on the coupon rate, length of time to the call, and market price.
If a bond is purchased at a discount, YTC will continue to be greater than YTM on a descending scale through consecutive call dates. For bonds purchased at a premium, YTC may be greater than or less than YTM, depending on the relationship between the purchase price and the call price. If the purchase price is lower than the call price, YTM should be lower. If the purchase price is higher than the call price, YTC should be lower.
Bond prices and yields have an inverse relationship. If bond prices go up, yields go down (and vice versa). If a bond is trading at a discount, the current yield will be higher than the coupon; if a bond is trading at a premium, the current yield will be lower.
In general, when comparing two callable bonds purchased at a discount, the bond with the interest rate that is farther from current market rates will be more volatile in price.
Yield curve
A yield curve is a chart consisting of the yields of bonds of the same quality but different maturities. It can be used as a gauge to evaluate the future of interest rates. An upward trend with short-term rates lower than long term rates is called a positive yield curve, while a down trend is a negative or inverted yield curve.
A positive yield curve is referred to as a normal yield curve due to the fact that most investors are willing to receive a lower yield for the benefit of liquidity (the ease with which an investment can be converted to cash without excessive loss of principal). Short-term investments tend to be more easily bought and sold (more liquid) than long term investments of the same type and quality. Therefore, investors are generally more willing to accept lower yields for shorter maturities. Conversely, investors who assume risks by purchasing longer-term maturities (market, interest rate, and time value of money) demand a higher yield in return.
A negative yield curve occurs when bonds with shorter maturities have higher yields than bonds with longer maturities. This is an unusual situation and occurs when short-term interest rates are temporarily very high and investors expect them to decline.
In certain rare cases, the yields of bonds with shorter maturities are the same as bonds with longer maturities. When this occurs, the yield curve is said to be flat, or even.
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