Mortgage-backed bonds/securities

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 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. 

Part Two discusses selected instruments traded in the debt capital markets. The products—hybrid securities, 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 structured product known as a collateralized debt obligation (CDO). Some of the techniques for analyzing these more complex products are explained. 

Callable bonds, putable bonds, mortgage-backed securities, and asset-backed securities are examples of (1). Floating-rate securities and inflation-indexed bonds are examples of (2). Convertible bonds and exchangeable bonds are examples of (3). 

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. 

While covered bonds are often regarded as similar to asset-backed securities (ABS) and mortgage-backed securities (MBS), many noteworthy differences exist between them ... 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

Convexity is a positive number for most normal bonds. However, for bonds with embedded call options such as mortgage-backed securities, it is always negative. Intuitively, it is obvious that if interest rates fall, the bond prices rise and the option to call the bond turns in the money and is often exercised, which shortens the duration of the bond and hence the rate of change of duration with respect to change in yields is negative. 

A CDO is a bond issued by an SPV that is secured by a pool of debt put by the issuer into a portfolio. As in the ABS, this pool is usually the sole recourse the investors will have for repayment of the notes. The pool may be composed of loans, securities, mortgaged backed securities or other ABSs. 

Effective duration recognizes that yield changes may effect the future cash flow of a bond and so its price. For bonds with embedded options the difference between traditional duration and effective duration can be significant. The effective duration of a callable bond, for example, is sometimes half its traditional duration. As noted in chapter l4, for mortgage-backed securities, the difference is sometimes greater still. 

In addition to the more traditional cash flows from mortgages and loan assets, investment banks underwrite bonds secured with flows received by leisure and recreational facilities, such as health clubs, and other entities, such as nursing homes. Bonds securitizing mortgages are usually treated as a separate class, termed mortgage-backed securities, or MBSs. Those with other underlying assets are known as asset-backed securities, or ABSs. The type of asset class backing a securitized bond issue determines the method used to analyze and value it. 

Unlike most other bonds, mortgage-backed securities pay monthly coupons, an advantage for investors who require frequent income payments. 

As noted earlier, stripped mortgage-backed securities, or stripped bonds, are created by splitting the cash flows payable by a pool of mortgages into interest and principal payments and assigning the two diflferent streams to two different classes of bonds interest-only, or lO, and principal-only, or PO, bonds. 

Thus the OAS is an indication of the value of the option element of the hond as well as the premium required by investors in return for accepting the default risk of the corporate bond. When OAS is measured as a spread between two bonds of similar default risk, the yield difference between the bonds reflects the value of the option element only. This is rare and the market convention is measure OAS over the equivalent benchmark government bond. OAS is used in the analysis of corporate bonds that incorporate call or put provisions, as well as mortgage-backed securities with prepayment risk. For both applications, the spread is calculated as the number of basis points over the yield of the government bond that would equate the price of both bonds. 

Clearly, investors that seek to invest in bonds that sell in high denominations, such as certain mortgage-backed and agency bonds, or bonds that are too "complex" for individual investors, including convertibles, sovereigns, junk, and derivative securities, would be better off investing in these securities through mutual funds. 

Most debt capital is raised by issuing long-term bonds. A mortgage is a bond that is backed by pledging a specific real asset as security against the loan. An unsecured bond is called a debenture. The ratio of total debt divided by total assets is known as the debt ratio (DR) or leverage of the company. 

Some bonds include a provision in their offer particulars that gives either the bondholder and/or the issuer an option to enforce early redemption of the bond. The most common type of option embedded in a bond is a call feature. A call provision grants the issuer the right to redeem all or part of the debt before the specified maturity date. An issuing company may wish to include such a feature as it allows it to replace an old bond issue with a lower coupon rate issue if interest rates in the market have declined. As a call feature allows the issuer to change the maturity date of a bond it is considered harmful to the bondholder s interests therefore the market price of the bond at any time will reflect this. A call option is included in all asset-backed securities based on mortgages, for obvious reasons. 

Some lending institutions penalize borrowers who retire their loans early. In the United States, prepayment penalties are levied only for commercial mortgages, not for residential ones (both are penalized in the United Kingdom). Residential lenders, therefore, cannot be certain of the cash flows they will receive. This is known as prepayment risk. The uncertainty of mortgages cash flows, and the risk associated with it, is passed on to the securities backed by the loans. In this way, an MBS is similar to a callable bond, with the call exercisable at the discretion of the borrowers, and, as will be explained later, it can be valued using a similar pricing model. 

Commercial mortgages are loans made against commercial property. A CMBS is created from a pool, or trust, of commercial mortgages, whose interest and principal payments back the bond s cash. It is rated in the same way as a residential mortgage security and usually includes a credit... 

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