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
–
•
Capital Structure Arbitrage
–
–
–
–
•
Long debt of one company and short debt of another in same industry; US and International
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
•
•
•
•
•
Credit/Distressed
–
Relies on mispricing of security risk
•
•
•
•
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
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 Risk
Trade 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 Issues
Duration
Credit
Treasuries; Global AAAs
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 Returns
1991-2004
High Yield
10 Year
Treasuries
High Yield
(1)
10 year
Treasuries
(2)
MBS (3)
ThreeMonth
Treasuries
(4)
High
Grade
Corporates
(5)
Stocks (6)
1.00
0.06
0.295
0.0348
0.3123
0.5120
1.00
0.83
0.72
0.93
(0.04)
1.00
0.29
0.09
0.23
1.00
0.18
0.09
1.00
0.12
MBS
3-mos
Treasuries
High Grade
Corporates
Stocks
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
1.00
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 Bor 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
CCC
Marginal
Default Rate
2.9%
6.9%
7.4%
Cumulative
Default Rate
2.9%
9.5%
16.2%
Marginal DR
8.0%
15.6%
19.6%
Cumulative DR
8.0%
22.3%
37.5%
Credit Markets and Credit
Derivatives
Market Forces Change the
Rules of Credit Investing
• Equity declines drove re-allocations
to fixed income
– Simultaneously government yields
decreased to all time lows
– Credit default rates neared all time
highs
– Pension fund shortfalls (Focus on
ALM)
• Credit markets are increasingly
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
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
Discussion Outline
• Recent market environment
• New market-implied techniques to
manage credit risk
• Introduction to the BDP (Barra Default
Probability)
• Practical Examples
• Questions and answers
Market-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 –
(ECR)
Empirical Credit Risk
Merton’s Structural Model of
Default
• Default occurs at debt maturity if the
firm value
is 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
No Default
V0
D
Default
0
T
Probability
of Default
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
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
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 MultiStrategy/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 Securities
Common 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
US Treasuries
25%
Mortgages
43%
US Agency
15%
ABS
2%
Sov/Supers
2%
Corporates
13%
(2002 Information)
What are Mortgage Backed “Pass-Through”
Securities?
+
+
=
Securitized
Mortgage Pool
or Pass-throughs
• 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)
Agency Conforming MBS Origination Process
Individual Mortgages
Residential loans
originated within the
conforming Agency
guidelines are
guaranteed by an
Agency, sold to the
Street then either
traded in passthrough form or used
to structure a CMO…
Average Balance $125,000
Gross WAC: 8.50%
Pooled by Mortgage Banks
Conforming
gg
GNMA
BOUGHT BY
AGENCIES
FHA/VA
8.50%
-.44 %
-.06 %
(servicing fee)
(guarantee fee)
8.00%
Judged for Sale by Balance
(2000 cap of $275,000),
Documentation and Pay Histories
8.50%
-.25 %
-.25 %
FNMA/FHLMC
8.00%
FNMA or FHLMC 30 Yr.
Mortgage Banking
(Sells - Buys)
TRADING
Trading Desk
CMO Desk
PO
6.5 yr
STRUCTURING
CMOs
REMICs
E.G.: $500 FNMA issue
END
PURCHASERS
PA
$250mm
5 yr
Agencies
~ 20%
PB
$50mm
10 yr
Banks &
Mortgage
Servicers
~ 40-50%
P2
$100mm
4 yr
F
Floater
$40mm
6.5 yr
Z
$50mm
20 yr
S
Inverse
Floater
$10mm
6.5 yr
Insurance
Companies &
Regional Desks
~ 20%
Non-Conforming
(next
page)
Non-Conforming MBS Origination Process
Individual Mortgages
Loans that do not
conform to Agency
standards are sold in
“whole loan” form or
structured into a
senior/subordinate
private label CMO…
Average Balance $125,000
Gross WAC: 8.50%
Pooled by Mortgage Banks
Conforming
(previous
page)
Judged for Sale by Balance
(2000 cap of $275,000),
Documentation and Pay Histories
Non-Conforming
Whole Loans
Either
Loan
Characteristics
Reviewed:
Geographical locations, zip code, property type,
pay history, original and current LTV,
occupancy, purpose, insurance
Willingness to Pay
Ability to Pay
Value of Asset
D e t e r m i n e d B y:
Credit Underwriters
GSMC
- Income verification
- Asset verification
- Financial ratios (FICOs)
- Tape data
- Current 12 month pay
history
- 30,60,90, 120+ day
delinquencies
- Age
Or
Custodian
- BPO
- Appraisal
- Geography
- Zip Code
Senior/Subordinate
96%
4%
Tranche by Credit
Tranche by Time
Aaa
$50 mm 6 yr
$30 mm 12 yr
Subordinated
Tranche
AA
A
BBB
BB
B
UR
15%
15%
12%
19%
12%
27%
13.1 yr
13.5 yr
13.8 yr
14.2 yr
15 yr
16 yr
Who Buys Mortgages?
Banks and
Agencies drive
investment flows
in the mortgage
market, holding
nearly 60% of all
MBS
Mortgage Security Holdings by
Investor Type in 2002…
Amounts in $US billions
Agencies
32%
Pension Funds
9%
Life Insurance Co's
11%
Foreign Investors
15%
Banks
24%
Other
8%
Overview of the U.S. Mortgage
Securities Market
•
Largest Sector of the U.S. Debt Market:
–
–
•
MBS can enhance portfolio performance significantly
–
–
•
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.
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.
72
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
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
75
Duration and Convexity
 price
•
Duration (simply):
•
Convexity is the change in Duration as yields change
 yield
Positive Convexity
Negative Convexity
Price
Price
45
40
40
35
35
30
30
25
gain from
convexity
25
20
15
15
10
10
5
5
2
3
gain from
convexity
(negative)
20
4
5
Yield (%)
6
7
8
0
2
3
4
5
Yield (%)
6
7
8
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?