Mortgage-backed securities backing

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. 

Mortgage-backed and asset-backed securities are backed by a pool of loans or receivables. For example, mortgage-backed securities are backed... 

Although it is commonly quoted by market participants, the cash flow yield suffers from limitations similar to the yield to maturity. These shortcomings include (1) the projected cash flows assume that the prepayment speed will be realized (2) the projected cash flows are assumed to be reinvested at the cash flow yield and (3) the mortgage-backed or asset-backed security is assumed to be held until the final payoff of all the loans in the pool based on some prepayment assumption. If the cash flows are reinvested at rate lower than the cash flow yield (i.e., reinvestment risk) or if actual prepayments differ from those projected, then the cash flow yield will not be realized. Mortgage-backed and asset-backed securities are particularly sensitive to reinvestment risk since payments are usually monthly and include principal repayments as well as interest. 

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. 

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

Commercial mortgage-backed securities (CMBS) represent an important and growing sector of the European securitisation market. However, in many cases there are significant differences between transactions, even those backed by collateral from the same originator, and it is these differences, in both collateral types and structural features, that make European CMBS such an interesting asset class. This chapter focuses on some of the more important aspects that investors should consider when analysing the collateral supporting these transactions and briefly looks at the key features of the common transaction structures. 

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. 

CASE STUDY EUROPEAN CDO OF MORTGAGE-BACKED SECURITIES ... 

As a way of pooling together all the considerations explored in this chapter, the best way is to demonstrate the major issues through a case study. We will use for this purpose, a CDO of mortgaged-backed securities. 

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