Amortizing bonds

Even payments to amortize 25 year, 4.5% 305,000 bond issue, calculated at 6.72% annually. 

Another way to calculate the yield return is the discounted margin. It differs from the simple margin because the first one amortizes the bond s premium or discount at a constantly compounded rate. The main disadvantage of this method is that it requires estimation of the reference rate over the bond s life. Assuming a bond paying semi-annual coupons, the discounted margin is given by (10.5) ... 

The source of dollar return called reinvestment income represents the interest earned from reinvesting the bond s interim cash flows (interest and/or principal payments) until the bond is removed from the investor s portfolio. With the exception of zero-coupon bonds, fixed income securities deliver coupon payments that can be reinvested. Moreover, amortizing securities (e.g., mortgage-backed and asset-backed securities) make periodic principal repayments which can also be invested. 

Within the CMO structure may be some PAC bonds with less prepayment risk than others, known as Type //and Type ///PACs. A Type II PAC has a narrower band than a standard PAC, thus reducing prepayment risk. If prepayment rates remain within their narrower bands. Type II PACs trade like standard PACs if rates move outside their bands, the extra cash flow is redirected to the companions only if the rates move above the range. Otherwise, there is no excess and the companion amortization is delayed. Type II PACs are second in priority to the standard PACs and so trade at a higher yield. If prepayment rates remain high for an extended period and all the companions are redeemed, the Type II PACs take over the function of companion and, with it, the higher prepayment risk. Type III PACs function like Type II PACs, but their band ranges are even tighter. 

Targeted amortization class, or TAG, bonds were created to cater to investors who require prepayment protection but at a higher yield than would be available with a PAC. Essentially, a TAG is a PAC whose band consists of only one standard prepayment rate. Like PACs, TACs amortize principal according to a schedule when the actual prepayment rate accords with this standard and, when the rate moves above it, use the extra principal amounts to pay off companion bonds. They differ from PACs mainly in taking on extra prepayment risk when prepayments fall below the rate required to maintain the payment schedule, extending the issues average life. Because one element of the PAC band is removed, TACs trade at a higher yield. 

Loans have less uniform terms than bonds, varying widely in their interest dates, amortization schedules, reference indexes, reset dates, maturities, and so on. How their terms are defined affects the analysis of cash flows. 

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