Agency Callable Bond Overview Collins

Agency Callable Bond Overview : Agency Callable Bond Overview California Municipal Treasurers Association 1/26/2006 Don Collins Brookstreet Securities Securities offered through Brookstreet Securities member NASD/SIPC. The content of this presentation is for information purposes only. The concepts discussed and opinions expressed are not necessarily endorsed by Brookstreet Securities Corporation. The strategies presented are not meant to be construed as guarantees against market loss and may not be suitable for all investors. The success of these strategies is dependent on market circumstances and results do vary. Past performance of securities and strategies is not a guarantee of future results.


Presentation Contents : Presentation Contents How does the Callable Bond Business Work? Agency Callable Bond Review Duration Value $ Convexity Yield Curves Call Option Callable Note Structures Valuing Callable Notes YTW AOAS, OAS GAP Callable Bond Strategies Comparison


GSEs (Government Sponsored Enterprises : GSEs (Government Sponsored Enterprises Fannie Mae ( FNMA) Federal Home Loan Mortgage Corporation (FHLMC), also known as Freddie Mac Federal Home Loan Bank System (FHLB), also known as Home Loan Federal Farm Credit Bank (FFCB), also known as Farm Credit Government National Mortgage Association (GNMA), also known as Ginnie Mae Student Loan Marketing Association (SLMA), also known as Sallie Mae Tennessee Valley Authority (TVA)


Where do Callables come from?Reverse Inquiry : Where do Callables come from? Reverse Inquiry Reverse Inquiry Customer has need for specific maturity and or call type and works with sales coverage, using indicative levels to determine the structure to best meet the investors needs. Standard settlement is 3 weeks, but can be customized to meet the investors needs. Plain Vanilla new issue callable typically price at par Once an investor narrows down the structure that is needed, the investor may utilize two different broker dealers to price the bond. This is most effective for FHLB deals and structured notes. More than one counter party will be used by the dealers Once the structure, settlement date, and amount is decided upon, the deal is priced by the callable agency trading desk in contact with the issuer or swap desk. The issuer, call structure, coupon rate and settlement date is locked, set and the bond is created. The cusip is assigned within a reasonable period.


Agency Driven Desk : Agency Driven Desk Customer is in the market for a callable agency and utilizes the NIM2 screens on Bloomberg, inventory pages, and messages sent from Broker Dealers to purchase a bond that has already been issued. Many of these deals may have been initiated through the reverse inquiry process or underwritten by desks that determined there was value in the structure and customer demand for the structure. Callable Agency Trading Desks are constantly seeking structures that are cheap in context of the overall market and based on color from customers. If a cheap deal becomes available for underwriting, the callable trader will underwrite without a lead order and sell the bonds to all interested customers.


FHLB - Behind the scene : FHLB - Behind the scene FHLB deals are typically swapped into floating rate debt and the optionality is sold. In this case, the callable desk will obtain swapped funding levels from a swap counter-party. The swap counter-party may be an internal or external desk. The callable trading desk typically prices with more than one swap counter-party in order to get the best coupon for the investor. Some swap desks may have axes in specific issues because of offsetting flows or differences in pricing models. Most callable traders will have a good idea of the swap counter-parties that are best for specific structures for plain vanilla callable structures, pricing should be standardized. For structured notes, such as callable capped floaters, models and axes can have a large impact. It is important to obtain pricing from two broker dealers for more esoteric structures.


FNMA/FHLMC : FNMA/FHLMC FNMA and FHLMC deals are typically not swapped. The optionality is needed to offset the optionality in the MBS portfolio on the asset side of the agencies balance sheet. In this case, the callable agency trading desk contacts FNMA and FHLMC directly to price the callable agency. This pricing should be fairly standardized as there is no swap counter-party involved, FNMA and FHLMC should be giving the same levels to all of the broker dealers, and the underwriting fees are standardized. The underwriting fees may be negotiable on larger deal sizes depending on the volume and type of overall business.


Change in Market Value : Change in Market Value 5 year agency bullet (GENERIC) 4.75% at par $1,000,000.00 MD = 4.37 Rates Market Value Change Gain/Loss Flat $1,000,000.00 0.00 +100 bp $ 957,302.00 -$42,695.00 - 100 bp $1,044,919.00 +$44,919.00 2 year agency Bullet (GENERIC) 4.625% at par $1,000,000.00 MD=1.93 Rates Market Value Change Gain/Loss Flat $1,000,000.00 0.00 +100 bp $ 980,843.00 -$19,157.00 - 100 bp $1,019,680.00 +$19,680.00


Duration : Duration Duration: The weighted average maturity of the security’s cash flows, where the present values of the cash flows serve as the weights. The greater the duration of a security, the greater its percentage price volatility Modified Duration: The percentage price change of a security for a given change in yield. The higher the modified duration of a security, the higher its risk.


Duration Graphically : Duration Graphically


Positive Convexity : Positive Convexity


Negative Convexity : Negative Convexity


5 yr nc 2 yr +- 100 BP : 5 yr nc 2 yr +- 100 BP


Yield Curves : Yield Curves


Yield Curve Inverted : Yield Curve Inverted


Living Yield Curve : Living Yield Curve http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve#menu   Yield curves Normal Investors expect the economy to run at normal rates of growth without significant changes in inflation rates or available capital. The yield curve slopes gently upward and investors expect to be compensated (higher interest rates) for extending maturities. (3M Bills to 30yr Treas = 300 bp) Steep This shape is typical at the beginning of an economic expansion and just after the end of a recession (economic stagnation has depressed short term rates but long term investors expect a reestablished demand for capital and an eventual rise in rates


Yield Curves : Yield Curves Yield Curves Inverted Paradox? Why invest long and settle for lower interest rates when short term investors take so much less risk? *** Long term investors expect the economy and rates to fall in the future. Inverted yield curves are rare. They have usually been followed by economic slowdown – or outright recession, and lower interest rates across the curve.


Yield Curves : Yield Curves Yield Curves Continued Flat and or Humped The yield curve must pass through this shape to become inverted – short term rates = long term rates. Not all Flat or Humped yield curves turn into inverted yield curves. Don’t discount this shape just because it does not guarantee a recession…… the odds are still pretty good that economic slowdown and lower interest rates will follow a period of flattening yields.


Rolling down the yield curve : Rolling down the yield curve


Why do Agencies issue Callables? : Why do Agencies issue Callables? Fund the purchase of MBS and hedge the interest rate risk of the MBS portfolio. Callables allow the agencies to better match the duration of assets (mortgages) and liabilities (debt instruments). FNMA and FHLMC typically retain the optionality in their callable debt to offset the optionality in their MBS portfolios. Callable debt allows the agencies to refinance debt as interest rates decline. This occurs at the same time that homeowners refinance mortgages. FHLB issues debt to provide advances to member banks for home mortgages and purchase mortgages. FHLB typically swaps issuance into floating and sells the optionality in callable debt.


U.S. Agency Callable Bonds : U.S. Agency Callable Bonds What is a Callable Agency? Debt securities with an embedded call option. The issuer will exercise the call option and redeem the bond when the market-determined yield of the new issue is below the yield on the outstanding bond. Example- mirrors the option that a homeowner has on their mortgage.


Callable Agency pricing : Callable Agency pricing Bullet Price - Call option price = Callable Bond Or, Yield callable = Yield bullet + Yield call option The Callable Bond investor is compensated for selling the call option in the form of an incremental yield pickup over non-callable Bullet Agencies. Embedded call option – Agency has the right, but not the obligation to redeem the bond (usually at par) after a specific lockout period.


Callable Agency Pricing : Callable Agency Pricing Interest rate volatility In theory, the value of any option increases with the volatility of interest rates. Shape and Level of Yield Curve Rising (Less option value with steep curve) Flat (Larger option value) Inverted ( largest option value)


Agency Call Structure : Agency Call Structure European Call One time Call on a pre-specified date after the initial lockout period Bermuda Call Semiannual or Quarterly call on a pre-specified schedule after the initial lockout period American Call Continuously callable after the initial lockout period ( anytime on or after the first call date) Canary Call A step-up bond that becomes non-callable when the first step has been reached. Lockout Period Period of time that the issuer cannot call the bonds ( settlement date to 1st call date)


Callable Agency Risk : Callable Agency Risk Negative Convexity Bond will not participate in a rally because it will be called When interest rates rise, the duration of callable bonds extend A callable that is discounted but still has optionality left (American call) will not trade like a bullet Reinvestment Risk Rates fall, bonds are called, proceeds invested at lower rates


Callable Agency Risk Continued.. : Callable Agency Risk Continued.. Cash Flow Uncertainty American calls etc. Spread Risk Agency spreads can widen reducing the total return on the bonds Structure Risk Esoteric structures, small issues can be difficult to value and will have less liquidity


Valuing Callable Securities : Valuing Callable Securities Yield Calculation Yield to Maturity Yield to Call Yield to Worst *** Always ask for the Yield to Worst***


Yield to Worst : Yield to Worst


Yield to Worst : Yield to Worst


Yield to Worst : Yield to Worst


YTC,YTM,YTW, TR : YTC,YTM,YTW, TR Yield to Maturity (YTM) Assumes that the bond will be held to maturity Assumes that the market will remain unchanged and volatility is not a factor Yield to Call (YTC) If called, the yield at the first call date If a premium is paid at purchase ( and the bond is called at the first call date), a loss of principal may occur If the bond is purchased at a discount ( and the bond is called at the fist call date), the YTC could be significant


YTC,YTM,YTW, TR : YTC,YTM,YTW, TR Yield to Worst The lowest yield that may occur at some future call date or at maturity, whichever is lower I.E. Premium paid …YTW = 1st call date I.E. Discount paid … YTW = Maturity date Total Return Incorporates price return and income return of the performance of a security over a specific time horizon


Making a Statement : Making a Statement By purchasing a callable security, we are making an interest rate prediction. How? Callable securities have performance limitations that are interest rate sensitive Perform well in a interest rate channel Fail outside of predicted interest rate channel What is the break even? (Broker will calculate)


Dissect a New Issue 3/1 1xCall : Dissect a New Issue 3/1 1xCall FNMA 5.10% 3/1 1xcall 500mm 1 year Bullet = 4.72% 3 year Bullet = 4.72% 2 year Bullet ( on forward curve = 4.72%) AOAS spread is 5.78, Duration = 2.74 Model’s determination of the total value of all imbedded options, based on the ask price of the bond (for AOAS only)


Option Adjusted Spread : Option Adjusted Spread OAS determines the component of a securities yield that is attributable to imbedded (call, put, or sink) options. I.E. When the treasury yield and other non-option related risk factors are subtracted out, the result is the OAS. This enables investors to measure their compensation for accepting an embedded option and the risks that come with it. Investors can compare the OAS of a callable debt security to the option-adjusted or Bullet spreads of other fixed-income securities when making investment decisions. Only as good as the volatility, and forward rate assumptions.


AOAS Screen : AOAS Screen


Interpreting the AOAS Screen : Interpreting the AOAS Screen FWD Strike: The projected at the money forward coupon for the term remaining on the bond at the call date. In the case of a 3/1/1xcall, it is the 2 yr agency bullet rate, 1 yr forward. ATM Vol: At the money swaptions volatility that matches the structure of the callable. For a 3/1 1x, the volatility input would be a 1yr into a 2 yr European swaptions volatility. Skew Adj. Vol: Volatility obtained by applying an adjustment factor (combining OAS-Adjusted Forward Par Yield and Coupon Rate) to the base volatility. Option Px Value: The Option price value is the present value of the option, in price points. For callable bonds this is a positive value that represents the theoretical cost of buying back the call option(s) that the investor is short Curve: Default curve. BMA-FHLMC Reference is the yield adjustment method


AOAS Screen: Methodology : AOAS Screen: Methodology OAS Method: The OAS calculations taking into account all embedded options. A yield does not appear because OAS considers all possible redemptions simultaneously, making it impossible to define a single yield. Option Free: the yield of the security if all options are removed. It is assigned a price by adding the values in the Price and Option Value fields. This price is then converted to a yield to maturity, which appears in this column. The spread is in respect to the selected benchmark with the nearest maturity. To Call on Date: The analysis of the bond using if it were trading to the call date. To Maturity: The analysis of the bond as if it were a bullet trading on a YTM basis


AOAS/OAS as a Relative tool : AOAS/OAS as a Relative tool AOAS can be used as a barometer of relative value along with other tools. It should not be used alone – I.E. A bond with a higher AOAS does not necessarily mean it is cheaper than a bond with a lower AOAS We must factor in the price of the bond, how far in or out of the money the option is, and the time remaining to call date.


Forward Curve : Forward Curve


Forward Rates : Forward Rates The forward rates are an indication of market expectations for interest rates and are based on current rates. For example, if the 1 yr agency rate today is 4.00% and 2yr agency is 4.50%, then the 1 yr agency rate 1 yr forward is 5% Therefore, if the forwards are realized, the investor is indifferent between rolling 1 yr agencies and buying a 2 yr agency. In this example, the forward rates are 100 basis points higher than current rates. Therefore, 1 yr rates would have to rise by more than this or the strategy of rolling 1 yr agency bullets to outperform. If rates fall, the 2 yr bullet would have been the best investment.


Options : Options Buy the 3 year non call 1 year 1 x call Or Buy a 3 year Bullet Or Buy a 1 year and reinvest in a 2 year Bullet one year from now…..


What is my Channel? : What is my Channel? 5.10%-4.72%=.38bp perMM/yr~=$3800 Break even drop is ~19 basis points on a 2 yr bullet. Or $3800/196=19.38 Break even rise is 5.30% on a 2 year Bullet in one year-------------5.10% = 4.72% for one year and 5.30% for two years. Channel for this bond is 4.53% to 5.30%


What is the likely outcome? : What is the likely outcome? Based on the current forward rate curve, we would anticipate the bonds being called. 5.1% coupon at the call date versus a 4.72% forward rate assumption on a 2 year bullet


One more. : One more.


Forward Curve : Forward Curve


Agency Bullet screen : Agency Bullet screen


Channel? : Channel? How much can rates drop on the 2 yr agency in 1.5 years? ~40bps/MM*1.5yrs~= $6000/196~=30 How much can rates rise on a 2 yr in 1.5 years? 5% ~= 4.6% for 1.5yr and 5.30% for 2 yrs *Channel 4.30% to 5.30% on 2 yr in 1.5 years. What does the future look like?


What about the GAP? : What about the GAP? Gap Breakeven Analysis Extended settlement new issues….. What is the cost to us? Use the GA3 screen on Bloomberg Term: Rate for the period between the start and end date. (Drop) Head: Rate for the period between the start and center date. (LAIF) Tail: Rate for the period between the center and end dates. ( Investment)


GAP for FHLMC 3/1 1x New Issue : GAP for FHLMC 3/1 1x New Issue


GAP for FHLMC 3/1 1x New Issue at call date : GAP for FHLMC 3/1 1x New Issue at call date


Make Callable Notes Sing! : Make Callable Notes Sing! Make maturity/call selection and expected probability of each. (I.E. expect rates to stay constant or rise) Options: 1 yr bullet = 4.72 3/1 1x call 5.10% coupon at par = 5.10% Should be called if rates rise by less than ~30 Bp 3/1 1x call, 6% coupon at 101.15 premium = YTC = 4.80% YTM = 5.57% High Probability of Call. Should be called if rates rise by less than 128 BP FYI, AOAS is 7.5 and 8.6 respectively


Quandary : Quandary We have a hole in our portfolio out 2 years. Current yield curve is slightly humped…. Possibly going to inverted. ( 12/27/05) Forward rates predict rates to begin falling next year. Current 2 yr bullet is 4.66% New issue 2yr/ 6mo B = 4.90% Settle 1/25 (4.86 Gap) New issue 4yr/2yr 1x = 5% Settle 12/28 New issue 5/2 cont = 5.30% Settle 1/11 ( 5.289 Gap) Secondary 2yr/1mo 1x 3.80% discount ~Bullet =4.71% Secondary 2yr/2 mo cont 3.375 coupon. Discount = 4.83% ytm


Compare/Contrast : Compare/Contrast  


Forward Curve : Forward Curve


Total Return Analysis for 3.375% : Total Return Analysis for 3.375%


Total Return Analysis for 5.30% : Total Return Analysis for 5.30%


Callable Bond Strategies : Callable Bond Strategies Premium Bonds Priced to call date. YTC=YTW OK if Rate rise expectation is quantified Discount Bonds Priced to Maturity YTM=YTW Again, Ok if Rate Drop is within investment parameters


Summary : Summary


Thank you : Thank you For more information regarding this presentation please contact me at Donald W. Collins 866-799-2578 dcollins@mail.bkst.com Securities offered through Brookstreet Securities member NASD/SIPC. The content of this presentation is for information purposes only. The concepts discussed and opinions expressed are not necessarily endorsed by Brookstreet Securities Corporation. The strategies presented are not meant to be construed as guarantees against market loss and may not be suitable for all investors. The success of these strategies is dependent on market circumstances and results do vary. Past performance of securities and strategies is not a guarantee of future results.