AAA and MBS Bonds

• Providing a choice of maturities
• Providing specific structures for institutional and retail needs
• Less erratic prepayment speeds

Mortgage-Backed Securities

What is a Mortgage-Backed Security (MBS)?

• An MBS is a debt instrument with a pool of real estate loans as the underlying collateral.
• The mortgage payments of the individual real estate assets are used to pay interest and principal on the security.

Mortgage Pass-Through

What is an Agency Mortgage Pass-Through Security?

• A security created when one or more holders of mortgages form a pool of mortgages and sell shares in the pool. A pool could consist of several thousand or just a few mortgages.
• The principal and interest form the pool of mortgages are passed-through to pay for the principle and interest of the security.
• The Trustee is either a US Federal Reserve Bank or the Government entity Ginnie Mae or agency Fannie Mae or Freddie Mac.

High Credit Quality

• GNMA securities are back by the "full faith and credit" of the U.S. government .
• Fannie Mae and Freddie Mac are US Government Agency's /Government Sponsored Enterprises created and charted by US Congress and carry an additional letter from credit of the US Department of Treasury.
• Ginnie Mae, Fannie Mae and Freddie Mac are therefore assured1 of receiving payments promptly each month regardless of whether the homeowners make their payments.
• Although neither Fannie Mae nor Freddie Mac securities carry the additional "full faith and credit" US government guarantee, the credit markets consider the credit on these securities to be equivalent to that of securities rated triple-A or better1.
• As an addtional investor protection, the CMO issuer typically segregates the CMO collateral or deposits it in the care of a "trustee", who holds it for the exclusive benefit of the CMO bondholders.
• The Trustee is either one of the twelve Federal Reserve Banks or the issuing agency.

MBS Cash Flow

Cash Flows of a Mortgage-Backed Security

Monthly Interest (I)
+
Scheduled Repayment of Principle (P)
+
Prepayments
_____________________
Total Cash Flows (P+I)

Floating Rate Notes

• A floating rate note (FRN) is a bond with a coupon that is adjusted periodically to a benchmark interest rate, or indexed to this rate. -Possible benchmark rates: US Treasury rates, LIBOR (London Interbank Offering Rates), prime rate, etc.
• Examples of floating-rate notes -Corporate (especially financial institutions) -Adjustable-rate mortgages (ARMs) -Governments (inflation-indexed notes)

Inverse Floating Rate Notes

• Unlike a floating rate note, an inverse floater is a bond with a coupon that varies inversely with a benchmark interest rate.
• Inverse floaters come about through the separation of fixed-rate bonds into two classes: -a floater, which moves directly with some interest rate index, & -an inverse floater, which represents the residual interest of the fixed-rate bond, net of the floating-rate.

Types of Risk

• Prepayment (call) risk
• Extension risk
• Re-investment risk
• Liquidity Risk
• Market Risk
• Interest Rate Risk
• Accurate Portfolio Pricing

Prepayment Risk

Understanding Prepayment Risk

• MBSs are repaid with the cash that mortgage loan borrowers pay as P & I due on their loans. Additional principal payments may create unexpected cash flows that may shorten the life of the bond.
• Prepayment risk is typically associated with 1) refinancing, 2) loan default, 3) sale of property and 4) additional principle paid to reduce borrowers debt 5) death
• Investor's portfolio performance can be affected by prepayment activity.
• Portfolio managers can utilize prepayment factors to effectively manage their portfolios in regards to YIELD and AVERAGE LIFE.

Extension Risk

• Extension Risk is defined as the lengthening of the life of a note due to the slowing of principal prepayments in a rising interest rate environment.
• Extension risk can be reduced by use of proper structure and collateral.

Re-investment Risk

Liquidity Risk

• Odd lot selling of instruments in an institutional market may result in lower than market pricing.

Market Risk

• Selling of an investment prior to its maturity or redemption date could subject the security to higher or lower pricing depending on prevailing market values.

Interest Rate Risk

• Inverse Floating Rate securities that rely on indexes (typically LIBOR) to reset their coupons are vulnerable to that index price. Increase yields of that index would cause a reduction of the coupon thereby reducing the yield on that investment.

Accurate Portfolio Pricing

• Due to the fact each CMO tranche is individually and uniquely structured, actual pricing for portfolios is done on a valuation basis only. Accurate prices can only be ascertained through actual bidding or market offering. Portfolios values must therefore be viewed as best estimates.

Summary

Mortgage-Backed Securities (MBS) may offer a combination of high credit quality, yield, liquidity, and monthly income. Principal which is backed by government and quasi-government agencies as well as direct US Government obligations offer opportunities for investors.