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Event Drive Hedge Funds
Ezra Zask
October 24, 2005
Event Driven Strategies
• Bankruptcy (in and out of…)– High Yield/Distressed– Credit Swaps
• Corporate reorganization; restructuring• Fundamental change in business environment;
competition• Lawsuits; legislation• M&A• Structured Bonds (Mortgage Backed Securities)
High Yield/Distressed Debt Investing
Fixed Income Markets and Funds
Fixed Income Strategies• Relative Value
– Long debt of one company and short debt of another in same industry; US and International• Capital Structure Arbitrage
– Long municipal debt, short corporate debt– Long senior debt, short subordinated– Long high yield, short equity– Long 1 year short 10 year of same company
• Event Driven– Relies on catalyst to release value
• M&A arbitrage• Bankruptcy or exit from bankruptcy• Corporate restructuring, exchange offers, recapitalization, asset sales, debt buyback• Ratings trigger downgrading from investment to high yield
• Credit/Distressed– Relies on mispricing of security risk
• High yield• Corporate credit arbitrage• Distressed securities (debt and equity)
• Directional Long/Short– Long
• Safer end of distressed (between high yield and distressed)• Secured Financing• Loan syndicated debt
– Short negative credit view of industry of issuer
Spectrum of Fixed Income Investing
Asset Backed Securities
Equipment
Commercial
Future Flow
Consumer
Special Situations
Direct Portfolio Lending
Mezzanine Lending
Distressed
Derivatives
CDO’s
Middle Market
Loans
High Yield Bonds
Real Estate
ABS
CDO
High Grade
Commercial Real Estate
Large Loans
Subordinated Classes
Direct Lending
Special Situations
Mezzanine Lending
Credit Derivatives
Correlation Trading
Credit Default Swaps
Baskets
Indices
Leveraged Credit
Leveraged Loans
Distressed
Mezzanine Debt
Special Situations
Direct Placement
High Yield Bonds
Convertibles
PIPES
ETC’s
Derivatives
Residential Mortgages
Home Equity
Alt-A
Prime
Whole Loans
CMO’s
Mezzanine Lending
Derivatives
High Grade Credit
Agencies
US Treasuries
Non-Dollar Treasuries
Repo
Futures
Interest Rate Derivatives
Governments
Agencies
US Treasuries
Non-Dollar Treasuries
Repo
Futures
Interest Rate Derivatives
Emerging Markets
Sovereigns
Corporate
Asset-Backed Securities
Direct Lending
Derivatives
Project Finance
Structured Finance
Commercial Real Estate
Municipals
General Obligations
Letters of Credit
Healthcare
Moral Obligations
Project Finance
Revenue Bonds
Distressed
Derivatives
Trade Strategies and RiskTrade Strategies Return Sources Risk Characteristics Typical Risk Allocation
HY Commercial Paper Carry Low 10-30%
Default Arbitrage Carry and Price Action Low 10-20
Short HY Basket, Long HY Market Basket
Carry and Price Action Low 20-30
Index Carry Trading Carry Low 10
Long HY Loan Market, Short HY Loan Basket
Price Action and Carry Low 20
HY Arbitrage Price Action and Carry Medium 0-30
Intracapital Price Action and Carry Medium 10-20
Long/Short Market Subsectors
Price Action Medium 10
New Issues Price Action Medium 5
L/S Specific Names Price Action High 30
Long Specific names Price Action, Carry High 10
Short Specific Names Price Action and Carry High 10
HY Municipals Price Action and Carry High 5
Cash/Derivatives Basis Trading
Price Action and Carry High 5
Single Name Volatility Price Action High 5
Global Fixed Income Market
Risk Sector IssuesDuration Treasuries; Global AAAs
Credit High Yield, Distressed, Emerging Market
Volatility Mortgages
Currency Non-dollar sovereigns; AAAs
Credit/Distressed/High Yield Sector Opportunities
• Stable credit markets and economic growth
• Lack of integration across credit spectrum (inflection points)– Investment to high yield– High yield to distressed– Across capital structure– Across term structure of debt in a company
Correlation of Monthly Returns1991-2004
High Yield (1)
10 year Treasuries (2)
MBS (3) Three-Month Treasuries (4)
High Grade Corporates (5)
Stocks (6)
High Yield 1.00 0.06 0.295 0.0348 0.3123 0.5120
10 Year Treasuries
1.00 0.83 0.72 0.93 (0.04)
MBS 1.00 0.29 0.09 0.23
3-mos Treasuries
1.00 0.18 0.09
High Grade Corporates
1.00 0.12
Stocks 1.00
Notes:(1) ML High Yield Master Index(2) ML 10 Year Treasury Index(3) ML Mortgage-Backed Index(4) ML three-month Treasury Index(5) ML High Grade Index(6) Wiltshire 5000 Stock Index
Benefits of High Yield and Distressed Investing
• Capital appreciation and high current income
• Diversified returns from various asset classes
• Market liquidity• Lower volatility than
equities, other
Correlation to Treasuries and Corporate Securities
1992-2004 US IT Govt
US LT Govt
LB Aggregate Bond
CSFB High Yield Index
0.00 0.11 0.19
CSFB Lev Loan Distressed Index
-0.05 0.00 -0.01
High Yield Investment Thesis
• Record new capital inflows, migration from other asset classes
• Interest rates near four decade lows– Search for yield, income– Rising rates hurt Treasury/Corporate debt
• Default rate in decline after 2002 peak• New issue market biased to stronger credits• Improving corporate balance sheets, corporate
governance, disclosure• Increase presence of commercial banks in
underwriting and trading
High Yield Investment Thesis (Continued)
• HY market remains inefficient– Long only charter of majority of investor base– Limited price transparency– Price sensitivity to funds flows– Dealer dominated market; liquidity “gaps”– Market not integrated to other parts of the
capital structure
State of High Yield Distressed Markets
• Historically low spreads• Near record level of issuance• Default rate in 2004 fell from 3.2% to 1.2%
– Long term average of 4.4%– 1994-1998 average of 2.1%
• Credit quality of new issues deteriorated by ratings, leverage and coverage ratio– Maintain discipline in high lead; leads to
opportunities in distressed
Definition of Distressed Investing
• Undervalued, under followed, out of favor of oversold securities
• Small to middle market companies• “Distressed” segment
– Companies in or near reorganization and/or default– Undervalued securities trading at deeply discounted
prices resulting from severe financial, operational or economic problems
• “Stressed” segment– Under followed or out of favor securities trading at
discounted prices resulting from cyclical or sector downturns, financial stress and uncertainties
Distressed Debt Opportunities
• Low interest rates, thirst for yield and improving economy led to record issuance of junk bond and leveraged loans in 2003-5
• Combined with mortality rates will yield high supply of distressed
Year Bonds B- or Lower
Leveraged Loans B+ or Lower
2002 3.4% 7.5%
2003 10.1% 20.8%
2004 20.6% (record)
34.5% (record)
Years After Issuance Until Default
Rating
B Marginal Default Rate
2.9% 6.9% 7.4%
Cumulative Default Rate
2.9% 9.5% 16.2%
CCC Marginal DR 8.0% 15.6% 19.6%
Cumulative DR 8.0% 22.3% 37.5%
Credit Markets and Credit Derivatives
• Equity declines drove re-allocations to fixed income
– Simultaneously government yieldsdecreased to all time lows
– Credit default rates neared all time highs
– Pension fund shortfalls (Focus on ALM)
• Credit markets are increasingly complex
– Universe of assets is expanding rapidly
– Spread products are becoming more complicated
– Limited headcount to cover expandingnumber of issues
Market Forces Change the Rules of Credit Investing
Market Forces Change the Rules of Credit Investing
Currently Very Few Easy Opportunities
• End of the bear credit market in 2003
• Spreads have tightened to extreme levels
– Lowest since 1998
• Demand still high
– Non-traditional investors
Source: S&P
Outperformance Is More Demanding Than Ever
• Are we being correctly compensated?
– Risk premium close to zero
• How does a long-only investor win/outperform?
– Spreads have nowhere to go
• Move to
– Lower-quality / higher-yielding
– Find names with value still
• Asset selection is key
• Recent market environment
• New market-implied techniques to manage credit risk
• Introduction to the BDP (Barra Default Probability)
• Practical Examples
• Questions and answers
Discussion Outline
Market-Implied Measures Provide Additional InsightMarket-Implied Measures Provide Additional Insight
Market-implied measures from the:
Equity Market – Barra Default Probabilities (BDP) Bond Market – Barra Implied Ratings (BIR) Derivatives Market – Credit Default Swaps (CDS)
Coming soon…
Crossover – Empirical Credit Risk (ECR)Equity Risk Implied Spreads (ERIS)
Merton’s Structural Model of Default
• Default occurs at debt maturity if the firm valueis below the liabilities value
• We thus need– A model of firm value process– Estimate of default point
• Merton identified equity as being long a call option on the firm value
• Merton identified a bond as being short a put option on the firm value
Merton’s Structural Model of Default
0
D
V0
No Default
Probability of Default
Default
T
Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision
Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision
The Market of Credit
• Size and sophistication of market has grown enormously- Notional exceed $2 trillion - Single name (CDS, CLN) to full blown portfolio
based instruments (FtD, Synthetic loss tranches, CDO squared)
• Initially used by bank loan managers to hedge
• Now: insurance companies, hedge funds, asset managers, etc
Credit Derivatives• Instruments whose payoff is a function of
a reference assets credit characteristics
• Transfer the ownership of credit risk between buyers (of protection) and sellers (of protection)
• Diversification, yield enhancement
• Credit risk is traded independently of the instruments that generate the risk
Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision
Single Name Credit Modelling• Structural approach: default when the company asset
value is less than its liabilities
• Spread relies on the internal structure of the company
• Can’t exactly fit a spread curve and can’t be used to price complex credit derivatives
• Reduced-form approach: the credit process is directly modelled via its probability of occurence
• Flexibility to fit a spread curve and extendable to price complex credit derivatives
Credit Default Swaps
• Most common credit derivative (over 50% of the market)
• Provides protection against default of a reference entity (isolates credit risk component)- Protection buyer retains market exposure
of reference entity- Protection seller gets leveraged exposure
to reference entity
Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision
Correlation Products Modelling• Contracts that reference the default of more than one
obligor• One of the fastest growing areas of credit derivatives
– nth-to-Default Baskets– CDO’s (static, managed, synthetic etc)
• Methodologies used to price these instruments– Default-time simulation (Normal, t, Archimedean copulas)– Semi-analytical approach
• The normal copula is the “benchmark” model for multi-obligor credit derivatives
Collateralised Debt Obligations• Application of securitisation technology
– Synthetically transferring assets off balance sheet via credit derivatives
• Asset pool is divided into tranches– Tranches have different risk/return characteristics – Payment to tranches is subordinated
• Risk on a CDO arises from the loss distribution of the underlying asset pool– Characteristics of individual underlying’s – Joint correlated behaviour of underlying’s
Agenda
• The Credit Market
• Single name credit
• Correlation products
• Latest Innovation
• Risk Vision
Latest Innovation
• CDS options
• Default Swaptions
• Credit Default Swap Index (Trac-x, iBoxx)
• CDO squared
• Option on CDO tranches
• Constant Maturity Default Swap (CMDS)
Growth of Credit Default Swaps
2000 2001 2002 2003 2004
Global CDS 893 1,189 2,306 3,500 4,920
US Corporate (IG + HY)
3,359 3,835 4,094 4,462 4,636
Special Situations/Events• Identify Drivers/Destroyers of Value
– Overcapacity– Cyclical downturns– Rising raw material costs– Outsourcing manufacturing and service– Elimination of trade/tariff barriers– Aging populations in developed nations
• Extraordinary events– Re-capitalization– Restructurings– Liquidations– Spin-offs– Management Changes– Contests for Control; Proxy Contests– Stock Repurchase; Special Dividend– Business Repositioning– Regulatory review/investigation
Credit Analysis• Net income is not cash
– EBITDA• EBITDA/Interest Expense• Long Term Debt/EBITDA• (EBITDA-Capital Expenditures)/Interest• EBITDA/Revenues
– Interest Expense– Capital Expenditures– Free Cash Flow– Long Term Debt– Debt Repayment Requirements
• Qualitative Analysis– Quality of management– Equity sponsors– Event Risk (Consolidation; IPO; Technology or Regulation issues; Refinancing– Cyclical vs. Defensive industry– Ranking and Capital Structure– Bond Covenants
Examples of Multi-Strategy/Event Funds
Examples of Multi-Strategy Funds
• Concordia– 25% to distressed, 12% to credit relative value and 11% to
volatility arbitrage. • Wexford
– 35% net long high yield against which they are carrying a 15% duration weighted short in treasuries and a 25% long position in the distressed book; 25% net long special situation equities.
• Deephaven– 30% in relative value equity, 25% in convertible arbitrage, 20%
in event driven, 10% in distressed/ capital structure arbitrage, 5% in global macro and 5% in credit opportunities.
Etolian Capital Credit Arbitrage
Kellner DiLeo Cohen & Co• Investment Strategies (market neutral)
– Merger Arbitrage Fund– Convertible Arbitrage Fund– Distressed and High Yield Securities Fund– Special Situations Fund– Multi-Strategy Fund
• 40% Distressed/high yield• 23% Convertible Arbitrage• 27% Merger Arbitrage• 10% Special Situations
• Investment Professionals– CIO– Three Portfolio Managers – Four analysts Distressed Analyst
• $600 mm under management
Pinewood Capital Partners
• Long, short and long/short positions in high yield & investment grade debt, commercial and industrial loans, municipal bonds and exchange traded and OTC derivatives
• Staffing– CIO– Director of Reseach + 3 analysts– Head Trader– Risk Manager
Dickstein Partners
• Event Driven Situations– Merger Arbitrage– Distressed/High Yield Securities– Event Driven Strategies
• $450 Capital
• Six Investment Professionals
Dickstein Partners
Canyon Capital
Canyon Organization
Canyon Credit Culture
Canyon Capital
Canyon Capital Direct Debt Investments
Canyon Capital
Angelo Gordon Alpha Credit Fund
• $8.5 billion in assets– 116 staff
• 56 investment professionals• 22 accounting/operations• 6 client service professional
• Percent of assets by strategy – Distressed securities – 30%– Leveraged loans (CLO) – 18%– Real estate – 18%– Convertible arbitrage – 12%– Merger Arbitrage – 4%– Cash – 10%– Other (Credit arbitrage, private equity, etc) – 18%
Angelo Gordon Alpha Credit Fund
• Intra-Company Credit Arbitrage– Senior vs. Subordinated– Parent vs. subsidiary– Short vs. long maturities– Bond vs. credit default swap– Bond vs. equity
• Inter-Company Arbitrage– Relative value within industry of credit rating– Individual credits vs. credit indices
• Outright Longs/Shorts– Longs/Shorts based on fundamental research
• Structured Transactions– Long/Short CDO hedging– Exploiting differences in instrument characteristics– Options on default swaps
Taconic Event Investing
• Portfolio Composition– Merger Arbitrage – 23%– Distressed/Stressed – 49%– Capital Structure Arbitrage – 32%
• Distressed/Stressed– Invest at the senior level (secured or senior); turns
into cash and/or credit worthy senior debt• Capital Structure Arbitrage
– Mispricing of different levels of stressed company’s capital structure
• Bonds underpriced because of bondholder fear and equity overpriced because of equity investors greed
– Long senior bond and short junior bond or equity
Sagamore Hill Multi-Strategy Market Neutral Investment Fund
• Net Return Target = Risk Free + 5-8%
• Areas of Focus– Event Driven
• Distressed, Special Situations, Merger Arb.
– Relative Value• Capital Structure, Equity
Neutral, Long/Short Credit
– Volatility Capture• Convertibles, Volatility
Trading
Strategy Current Allocation
Event 16%
Distressed 16%
Merger Arbitrage 15%
Capital Structure 14%
Long-Short Credit 7%
Equity Market Neutral
7%
Convertible Arbitrage
16%
Volatility Arbitrage 9%
Sagamore Hill Strategies: Event Driven
• Distressed– Fundamental-driven research of securities in, near or recently
emerged from bankruptcy– Domestic and European allocation– Deal sourcing; on the run; private opportunities
• Event Driven – Special Situations– Mispriced securities with clear valuation catalysts including
litigation, regulatory actions, spin-offs, refinancing– Excess returns from superior due diligence to capture excess
risk premiums created by risk averse investors• Merger Arbitrage
– Quantitative, fundamental and regulatory concerns– Use of options to mitigate risk and add value– Domestic and European focus
Sagamore Hill Strategies:Relative Value
• Capital Structure Arbitrage– Intra-company relative value among securities and derivatives
within a capital structure• Debt-equity, debt-option, senior-subordinated, structural arbitrage
and pari-passu• Balanced portfolio has minimal risk exposures
• Long-Short Credit– Fundamental credit research
• Asset values, business fundamentals, legal considerations and capital structure
– Domestic and European allocation– Isolate mispriced credit risk
• Equity Market Neutral– Equity Long/Short– Statistical quantitative equity portfolio construction
Sagamore Hill Strategy:Volatility Capture
• Convertible Arbitrage– Global portfolio– Mispriced volatility, credit risk, event risk– Quantitative and fundamental valuation techniques– Integration of convertible with other strategies within
the firm• Volatility Arbitrage
– Relative value trading (time spreads, skew and dispersion trades)
– Relative value between derivatives of related securities
– Focus on equity and foreign exchange markets
Structured Credit Programs
Mortgage Backed Securities
• Value Proposition– Mortgage market is large, liquid but not entirely efficient– Preferred Habitat by major players indifferent to relative value
• Banks buy to yield; shorter-duration mortgages• Homeowners borrow to buy/refinance; must pay current coupon• Mortgage servicers driven by hedging needs
• Mortgage Backed Securities and Related Instruments– Mortgage pools; adjustable rate loans; interest only loans;
balloon payment loans; non-performing loans; Commercial MBS; Private Label Mortgage Securities; CMOs, Mortgage derivatives, etc.
• Position Analysis– Risk/cheapness; Carry; Duration; Convexity– Identify shifts in investor preferences
JP Morgan Asset Management
• Program Details– Leverage of 10-15 times net assets– Return objective 8-12% over full market cycle (3-5
years)– $30 bln in long and long/short
• Organization– Three senior mortgage portfolio managers– Three quantitative research and risk management
analysts– Support from head of fixed income
Mortgage Backed SecuritiesCommon Types of Trades
• Coupon Swap: Long one coupon vs. duration-neutral short position in another coupon– Buy FNMA 6%, Sell FNMA 5.5%
• Trading Rolls: Long coupon in one settlement month vs. short same coupon in different month– Buy Sep GNMA 6%; Sell Oct GNMA 6%
• Butterfly: Long “center” short “wings”– Buy FNMA 6%, Sell FNMA 5.5% and 6.6%
• Agency-to-Agency: Long/short agencies in same coupon– Buy FNMA 5.5%, sell GNMA 5.5%
• 30-year vs. 15-year: Buy FNMA 20 year 5%, Sell FNMA 15 year 4.5%
• Mortgage vs. Treasuries or Swaps: Long (or Short) mortgage basis with expectation of spread compression (or widening) vs. Treasuries or swaps
Basis Yield Alpha Fund• Diversified Global Structured Credit Securities and Derivatives
– Asset Backed Securities (ABS)– Mortgage Backed Securities (MBS)– Collateralized Debt Obligations (CDO)– Collateralized Loan Obligations (CLO)
• Market Opportunities– Diversification benefits of pool of assets and high recovery rates– Lower default risk and credit migration– Uncorrelated to other asset classes– Premium from Illiquidity and complexity and because traditional fund
manager investment mandates stop at investment grade– Issuance in 2004 of $160 billion
• Personnel– Three portfolio managers– Four analysts
Concordia Advisors
• Concordia Advisors hired Christopher Dillon and James Wise, former co-heads of JPMorgan’s tax-exempt structured product group to manage a new fund, The Concordia Municipal Opportunities Fund, which will launch Oct. 1.
• Fixed income, interest rate neutral relative value fund will invest exclusively in the U.S. municipal bond market.
• Concordia has $1.2 billion in assets under management in eight other hedge funds.
Introduction to Asset Securitization
• “What is a Mortgage”
• Mortgages as a Fixed Income investment
• What else can you securitize?
Tradable Fixed Income Supply
U.S. Dollar Denominated Debt Market
Mortgages43%
ABS2% Sov/Supers
2%
Corporates13%
US Agency15%
US Treasuries25%
(2002 Information)
What are Mortgage Backed “Pass-Through” Securities?
• A number of similar mortgages (underlying collateral, design, rates and maturities) are combined into a single group
• Mortgage documents associated with this group are delivered to a custodian and are assigned an identification (pool) number
• A Mortgage Backed Security (MBS) is issued with a face amount equal to the cumulative outstanding principal balance of the mortgages (original balance)
• The mortgages that have been pooled together serve as the collateral for the security
• Most MBS are guaranteed and/or issued by a U.S. Government Agency (FNMA, Freddie Mac or GNMA)
+ + = SecuritizedMortgage Pool
or Pass-throughs
SecuritizedMortgage Pool
or Pass-throughs
Agency Conforming MBS Origination Process
(next page)
Pooled by Mortgage Banks
Individual Mortgages Average Balance $125,000
Gross WAC: 8.50%
Judged for Sale by Balance (2000 cap of $275,000),
Documentation and Pay Histories
Mortgage Banking (Sells - Buys) Trading Desk
CMO Desk
E.G.: $500 FNMA issue
PO 6.5 yr
S Inverse Floater $10mm 6.5 yr
PA $250mm
5 yr
PB $50mm 10 yr
STRUCTURING CMOs REMICs
END PURCHASERS
Non-Conforming Conforminggg
Banks & Mortgage Servicers
TRADING
8.50% -.44 %
-.06 % 8.00%
(servicing fee) (guarantee fee)
8.50% -.25 %
-.25 % 8.00%
FNMA/FHLMC
FNMA or FHLMC 30 Yr.
GNMA BOUGHT BY AGENCIES
FHA/VA
P2 $100mm
4 yr
F Floater $40mm 6.5 yr
Z $50mm 20 yr
Agencies ~ 20%
Insurance Companies &
Regional Desks ~ 20% ~ 40-50%
Residential loans originated within the conforming Agency guidelines are guaranteed by an Agency, sold to the Street then either traded in pass-through form or used to structure a CMO…
Non-Conforming MBS Origination Process
(previouspage)
Pooled by M ortgage Banks
Ind iv idua l M ortgages
A verage B a lance $125 ,000
G ross W A C : 8 .50%
Judged fo r S a le by B a lance(2000 cap o f $275 ,000),
D ocum en ta tion and P ay H is to riesNon-Conforming
Either W hole Loans
G eograph ica l loca tions , z ip code , p roperty type ,pay h is to ry, o rig ina l and cu rren t LTV ,occupancy, pu rpose , insu rance
Ability to Pay W illingness to Pay Value of Asset
- Incom e verification- Asset verification- F inancial ratios (F ICO s)
- Tape data- Current 12 m onth pay
history- 30,60,90, 120+ day
delinquencies- Age
- B P O- A ppra isa l- G eography- Z ip C ode
D e t e r m i n e d B y:
LoanC harac te ris ticsR eview ed :
Or Senior/Subordinate96%
Aaa
4%
SubordinatedT ranche
Tranche by C redit
A A 15% 13.1 yrA 15% 13.5 yrB B B 12% 13.8 yrB B 19% 14.2 yrB 12% 15 yrU R 27% 16 yr
Tranche by T im e
$50 m m 6 yr$30 m m 12 yr
Conforming
Credit Underw riters G SM C Custodian
Loans that do not conform to Agency standards are sold in “whole loan” form or structured into a senior/subordinate private label CMO…
Who Buys Mortgages?
Mortgage Security Holdings by Investor Type in 2002…
Amounts in $US billions
Banks and Agencies drive investment flows in the mortgage market, holding nearly 60% of all MBS
72
Overview of the U.S. Mortgage Securities Market
• Largest Sector of the U.S. Debt Market:– Aggregate current principal amount outstanding mortgage loans is over $4.9 trillion
as compared to about $3.3 trillion of government securities and $4.4 trillion of Corporate bonds.
– Mortgage backed securities (MBS) are an integral part of any broad portfolio exposure to the U.S. Government securities. The U.S. investment grade corporate debt market is less than 1.5 trillion in size.
• MBS can enhance portfolio performance significantly– Major mortgages indices have outperformed comparable duration U.S. Treasuries by
an average of more than 140 bp over the past 10 years.
– The U.S. mortgage market consists of a wide array of securities to suit most investor needs. A full range of credit qualities, durations, risk profiles and yields exist in this market.
• High Credit Quality– Most of the MBS market is issued by U.S. Government agencies which have an
implied AAA rating: GNMA issues carry full faith and credit of the U.S. Government, Fannie Mae and Freddie Mac have the implicit backing of the U.S. Government.
– Non-agency mortgage securities mostly consist of AA or better rated bonds. Lower rated securities (down to single-B) are also available.
What’s the catch?
• You are purchasing a product with an imbedded call option– Duration is very hard to determine.– Variability in Average Life can be substantial
• You are purchasing an amortizing product– Reinvestment of Principal monthly can reduce
yield.
"Duration" Deserves Special Focus in Mortgages...
• Modified duration, Macaulay duration, cashflow duration: all measure a mortgage's price sensitivity to rate movements, assuming the cashflows are held constant.– Usually not a good assumption in mortgage product owing to
prepayments– Durations often quoted as a percentage of modified duration
• Option-adjusted duration (OAD), model duration: measure price sensitivity for small rate movements, assuming constant OAS– Doesn't account for how securities actually trade– Reliant on prepayment model
• Empirical duration, EOAD: regression of performance vs rates– can be price or OAS vs rates– adjusted for volatility, slope of the curve
75
Prepayment Risk
• Prepayment Option– Any payments by borrower made in excess of scheduled principal
payments are called prepayments– The option is defined by the borrower's right to prepay all or part of the
mortgage at any given time– The uncertainty for the mortgage holder which results is termed
prepayment risk
• Prepayment Motivation– Prepayment may occur for one of several reasons
• sale of property
• default
• refinancing
– Motivations beyond rational economic considerations play an important roll in assessing prepayment risk
• Risk for Mortgage Holder– Interest rate risk (re-investment risk): Should mortgage be fixed-rate,
market risk arises as a result of prepayment if rates fall and coupons are above market
– Liquidity risk: Should mortgage portfolio be securitized for debt issuance, prepayment implies the need to raise new financing
Duration and Convexity
• Duration (simply):
• Convexity is the change in Duration as yields change
yield
price
2 3 4 5 6 7 80
5
10
15
20
25
30
35
40
Yield (%)
gain from
convexity
(negative)
2 3 4 5 6 7 85
10
15
20
25
30
35
40
45
Yield (%)
gain from
convexity
Price PricePositive Convexity Negative Convexity
Options and Convexity
• If you are long a call option – are you long gamma or short gamma?
• Why is being long an MBS similar to being short a call option? Who are you short this option to?
• Can you hedge this with options?
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