Mortgage bond market

The mortgage bond market in France dates back to 1852 when, on 28 February, the Decree of 1852 established mortgage banks that were authorized to lend funds to property owners. These loans were repay-... 

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. 

The market has grown considerably from the lowly position it found itself in, midcentury, a period when mortgage banks reported business volumes down to levels of 5% of those quoted just 30 years earlier, to it current status as one of the largest bond markets in the world. 

The Irish covered market is the most recent in Europe. When Ireland sought to create their covered bond market, they looked at all the relevant laws already in place throughout Europe, and cherry-picked the most attractive factors from an investor s perspective. What made this initiative even more impressive was the fact that Ireland has no history in issuing mortgage bonds. 

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. 

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. 

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. 

To gain exposure to sectors where, for various reasons, they do not wish to make actual purchases, investors can use a variation on a TR swap called an index swap, in which one of the counterparties pays a total return tied to an external reference index and the other pays a LIBOR-linked coupon or the total return of another index. Indexes used include those for government bonds, high-yield bonds, and technology stocks. Investors who believe that the bank loan market will outperform the mortgt e-backed bond sector, for instance, might enter into an index swap in which they pay the total return of the mortgage index and receive the total return of the bank-loan index. 

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

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. 

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. 

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. 

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. 

Hayre, L., and C. Mohebbi. 1989. Mortgage Pass-Through Securities. In Fabozzi, F., ed. Advances and Innovations in the Bond and Mortgage Markets. Probus Pubhshing, 259—304. 

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