Mortgage-backed bonds

This chapter describes the German mortgage-bonds or Pfandbriefe market, its institutions, and working practice. We also consider other aspects of the European covered bond market. The instruments themselves are essentially plain vanilla bonds, and while they can be analysed in similar ways to US agency bonds and mortgage-backed bonds, there are also key differences between them, which we highlight in this chapter. Mortgage-backed securities are described in Chapter 11. 

This distinction between the two translated, until recently, into very little in practice. However, as the mortgage banks, in common with all German banks in the latter half of 2002, experienced significant credit deterioration these different approaches have become far more apparent. Pfandbrief paper from the same issuer is now rated differently by the two main rating agencies for example, Moody s now rates AHBR s mortgage-backed bonds A1 whereas S P still maintains a triple-A outlook. 

Part Two discusses selected instruments traded in the debt capital markets. The products—hybrid secmities, mortgage-backed bonds, and callable bonds—have been chosen to give the reader an idea of the variety available in the market. Also described are index-linked bonds and a strucmred product known as a collateralized debt obligation (CDO). Some of the techniques for analyzing these more complex products are explained. 

Hayre, Mohebbi, and Zimmermann (1998) list the following advantages of mortgage-backed bonds ... 

Their yields are usually higher than those of corporate bonds with the same credit rating. In the mid-1990s, mortgage-backed bonds traded around 100 to 200 basis points above Treasury bonds by comparison, corporates traded at a spread of around 80 to 150 for bonds of similar credit quality. This yield gap stems from the mortgage bonds complexity and the uncertainty of mortgage cash flows. 

Agency mortgage-backed bonds are implicitly backed by the government and therefore represent a better credit risk than triple-A-rated corporate bonds nonagency bonds are often triple-A or double-A rated. 

The market is large and thus very liquid agency mortgage-backed bonds have the same liquidity as Treasury bonds. 

As already noted, the exact term of a mortgage-backed bond cannot be stated with assurance at the time of issue, because of the uncertainty connected with the speed of mortgage prepayments. As a result, it is not possible to analyze these bonds using the same methods as for fixed-coupon bonds. The most common approach is to assume a fixed prepayment rate—recognizing that, in reality, it will fluctuate with changes in mortgage rates and the economic cycle—and use this to project the bond s cash flows and thus its life span. The prepayment rate selected obviously is very important. This section considers some of the ways the rate is arrived at. 

Combining these values, as in (14.12), gives the total cash flow that a holder of a mortgage-backed bond receives in any month. 

Using a projected prepayment rate enables analysts to evaluate mortgage-backed bonds. The original PSA benchmarks were based on the observation that prepayment rates tend to stabilize after the first thirty months of a mortgage and assumed a linear increase in these rates. They do not reflect seasonal variations in prepayment patterns nor the different behavior patterns of different types of mortgages. 

One of the demands that drove the design of CMOs was for mortgage-backed bonds with a wider range of maturities. Most CMO structures redirect principal payments sequentially to individual tranches, according... 

As explained in chapter 2, a bond s modified or Macaulay s duration is the average time to receipt of its cash flows, weighted according to their present values. To compute a mortgage-backed bond s duration, it is necessary to project its cash flows using an assumed prepayment rate. These projections, together with the bond price and the periodic interest rate, derived from the yield, may then be used to arrive at the bond s periodic duration, which is divided by twelve (or four, in the case of a bond that pays quarterly) to arrive at its duration in years. 

There are a number of ways to calculate the yield on a mortgage-backed bond. One of the most common is the static cash flow model. This assumes a single prepayment rate to estimate the cash flows for the bond and does not take into account how changes in market conditions might affect the prepayment pattern. 

Equation (14.15) computes the yield for a bond making monthly coupon payments (as the majority of mortgage-backed bonds do, although some pay quarterly). For purposes of comparison, this figure must be converted to a bond-equivalent yield. Equation (14.16) derives the annualized bond-equivalent yield for a mortgage-backed bond paying monthly coupons. 

Cash flow yield calculated in this way is essentially a redemption yield calculated assuming a prepayment rate to project the cash flows. As such, it has the same drawbacks as the redemption yield for a plain vanilla bond it assumes that all the cash flows will be reinvested at the same interest rate and that the bond will be held to maturity. In fact, the potential inaccuracy is even greater for a mortgage-backed bond because the frequency of interest payments is higher, which makes the reinvestment risk greater. The final yield of a mortgage-backed bond depends on the performance of the mortgages in the pool—specifically, their prepayment pattern. 

Given the nature of a mortgage-backed bond s cash flows, its exact yield cannot be calculated. Market participants, however, commonly compare an MBS s cash flow yield to the redemption yield of a government bond with a similar duration or a term to maturity similar to the MBS s average life. The usual convention is to quote the spread over the government bond. 

As noted in chapter 3, it is possible to calculate a bond s price given its yield and vice versa. As with a plain vanilla bond, a mortgage-backed bond s price is the sum of the present values of its projected cash flows. The discount rate used to derive the present values is the bond-equivalent yield converted to a monthly basis. 

The optionality of a mortgage-backed bond, and the volatility of its yield, frequently have a negative impact on the bondholders. This is for two reasons the actual yield realized during the holding period has a high probability of being lower than the anticipated yield, which was calculated on the basis of an assumed prepayment level, and mortgages are frequently prepaid when the bondholders will suffer the most—that... 

Because OAS analysis takes into account a mortgage-backed bond s option feature, it is less affected by a change in interest rates or the yield curve, which affect prepayments, than the bond s yield spread. Assuming a flat yield curve, the relationship between the OAS and the yield spread is expressed in equation (14.18). 

The modified duration of a bond measures its price sensitivity to a change in yield. It is essentially a snapshot of one point in time. It assumes that no change in expected cash flows will result from a change in market interest rates and is thus inappropriate as a measure of the interest rate risk borne by a mortgage-backed bond, whose cash flows are affected by rate changes because of the prepayment effect. 

To assess the value of a mortgage-backed bond over a given investment horizon, it is necessary to measure the return generated during the holding period from the bond s cash flows. This is done using the total return framework. 

Computing total return starts with calculating total cash flows. A mortgage-backed bond s cash flows comprise ... 

This chapter examines a number of issues relevant to participants in the fixed-income markets. The analysis presented is based on government-bond trading and is confined to generic bonds that are default-free, with no consideration given to factors that apply to corporate bonds, asset- and mortgage-backed bonds, convertibles, or other nonvanilla securities, or to issues such as credit risk and prepayment risk. Nevertheless, the principles adduced are pertinent to all relative-value fixed-income analysis. 

The modified duration and convexity methods we have described are only suitable for use in the analysis of conventional fixed-income instruments with known fixed cash flows and maturity dates. They are not satisfactory for use with bonds that contain embedded options such as callable bonds or instruments with unknown final redemption dates such as mortgage-backed bonds. For these and other bonds that exhibit uncertainties in their cash flow pattern and redemption date, so-called option-adjusted measures are used. The most common of these is option-adjusted spread (OAS) and option-adjusted duration (OAD). The techniques were developed to allow for the uncertain cash flow structure of non-vanilla fixed-income instruments, and model the effect of the option element of such bonds. 

Option-adjusted spread analysis uses simulated interest rate paths as part of its calculation of bond yield and convexity. Therefore an OAS model is a stochastic model. The OAS refers to the yield spread between a callable or mortgage-backed bond and a government benchmark bond. The government bond chosen ideally will have similar coupon and duration values. 

Mortgage-backed bonds not issued by government agencies are rated in the same way as other corporations. Some nongovernment agencies obtain mortgage insurance for their issues, to boost their credit quality. The credit rating of the insurer then becomes an important factor in the... 

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