Personal Investment Management
ADMS 3531 - Fall 2011 – Professor Dale Domian
Lecture 10 Part 2 – Government Bonds and Mortgage-Backed
Securities – Nov 22
Chapter 19 Outline
- Government bond basics.
- Treasury bills, notes, bonds and strips.
- Bank of Canada auctions.
- Canada Savings Bonds.
- Provincial and municipal bonds.
- Mortgage-Backed Securities.
- A brief history of Mortgage-Backed Securities.
- Fixed-rate mortgages.
- Canada Mortgage and Housing Corporation.
Government Bond Basics
- In 2003, the gross public debt of the Canadian government was approximately $120
billion.
- The Bank of Canada finances government debt by issuing marketable as well as nonmarketable securities.
- Provincial and municipal government debt is also a large debt market.
- Marketable securities can be traded among investors.
- Marketable securities issued by the government include T-bills, and Canada Bonds.
- Non-marketable securities must be redeemed by the issuer.
- Non-marketable securities include Canada Savings Bonds.
Canada Bond
- Canada bonds are long-term obligations with maturities of more than 10 years
(when issued).
- Canada bonds pay semi-annual coupons (at a fixed coupon rate) in addition to their
face value (at maturity).
STRIPS
- Separate trading of registered interest and principal of securities.
- Originally derived from Canada bonds.
o A 30-year bond can be separated into 61 strips – 60 semi-annual coupons [+]
a single face value payment.
-
STRIPS are effectively zero coupon bonds (zeroes).
The YTM of a STRIP is the interest rates the investors will receive if the STRIP is
held until maturity.
Straight Bond Prices and Yield to Maturity
- Recall: The price of a bond is found by adding together the present value of the
bond’s coupon payments and the present value of the bond’s face value.
Real Return Canadian Bonds
- In recent years, the Bank of Canada has issued securities that guarantee a fixed rate
of return in excess of realized inflation rates.
- These inflation-indexed Canadian bonds:
o Pay a fixed coupon rate on their current principal, and
o Adjust their principal semi-annually according to the most recent inflation
rate.
Bank of Canada Auctions
- The Bank of Canada conducts regularly scheduled auctions for government
securities.
- At each treasury auction, the Federal Reserve accepts sealed bids of two types.
o Competitive bids specify a bid price/yield and a bid quantity. Such bids can
only be submitted by treasury securities dealers.
o Non-competitive bids specify only a bid quantity, and may be submitted by
individual investors.
- The price and yield of the issue is determined by the results of the competitive
auction process.
Auctions, More Details
- All non-competitive bids are accepted automatically and are subtracted from the
total issue amount.
- Then, a cut-off yield is determined. This is the price at which all competitive bids are
sufficient to finance the remaining amount.
- All bids at or above the cut-off yields are accepted.
Canada Savings Bonds
- The Bank of Canada offers an investment opportunity of individual investors by
issuing two types of Savings Bonds: regular interest and compound interest bonds.
These bonds:
o Have face value denominations ranging from $100 to $10,000.
o Accrue interest semi-annually and,
o Can be redeemed for the original price plus all prior accrued interest at any
Canadian financial institution.
o They are non-callable and non-transferable.
Canada Premium Bonds
- Very similar to Canada Savings Bond.
- However they provide higher returns.
- Accrue interest semi-annually (the interest rate is set as a fixed rate plus the recent
inflation rate), and
- Can be redeemed for the original price plus all prior accrued interest once a year.
Provincial and Municipal Bonds
- Provincial and municipal bonds are intermediate- to long-term interest-bearing
obligations of provincial and local governments, or agencies of those governments.
- They are RRSP eligible and provide tax deduction in retirement plans.
Types of Municipal Bonds
- Bonds issued by a municipality that are secured by the full faith (are known as
general obligation bonds (GOs)).
- Municipal bonds secured by revenues collected from a specific project or projects
are called revenue bonds.
o Example: Airport and seaport development bonds that are secured by user
fees and lease revenues.
Mortgage-Backed Securities
- Next we will examine the investment characteristics of mortgage pools.
- Mortgage pools are simply sets of home mortgages, which are ‘bonds’ issued by
home owners.
A Brief History of Mortgage-Backed Securities
- Traditionally, local banks wrote most home mortgages and then held the mortgages
in their portfolios of interest-earning assets.
- Then, when market interest rates climbed to near 20% in the early 1980s, bank
customers flocked to withdraw funds from their savings deposits to invest in money
market funds.
- Today, a mortgage originator usually sells the mortgage to a mortgage repackager,
who accumulates them into mortgage pools.
- Financed by mortgage-backed bonds (also called mortgage pass-throughs), each
mortgage pool is set up as a trust fund.
-
A servicing agent collects the mortgage payments from the home-owners and then
passes the cash flows through to the bondholders.
The transformation from mortgages to mortgage-backed securities (MBSs) is called
mortgage securitization.
Fixed-Rate Mortgages
- A fixed-rate mortgage is a loan that specified constant monthly payments at a fixed
interest rate over the life of the mortgage.
- The size of the monthly payment is determined by the requirement that the present
value of all monthly payments, based on the financing rate specified in the mortgage
contract, be equal to the original loan amount.
Monthly Payments
- In Canada mortgage payments are compounded semi-annually and therefore we
have to use effective annual rate instead of annual fixed rate.
Fixed-Rate Mortgage Amortization
- Each monthly mortgage payment has two separate components:
o Payment of interest on outstanding mortgage principal.
o Pay-down, or amortization, of mortgage principal.
- The relative amounts of each component change throughout the life of the mortgage.
- Mortgage amortization can be described by an amortization schedule.
- An amortization schedule states the scheduled principal payment, interest payment,
and remaining principal owed in any month.
Fixed-Rate Mortgage Prepayment and Refinancing
- A mortgage borrower has the right to pay off all or part of the mortgage ahead of its
amortization schedule. This is similar to the call feature of corporate bonds and is
known as mortgage prepayment.
- During periods of falling interest rates, mortgage refinancing is an important reason
for mortgage prepayments.
- This means that mortgage investors face the risk of a reduced rate of return.
Canada Mortgage and Housing Corporation
- The Canada Mortgage and Housing Corporation (CHMC), is a government agency
charged with the mission of promoting liquidity in the secondary market for home
mortgages.
- Mortgages in CHMC pools are said to be fully modified because CHMC guarantees
bondholders full and timely payment of both principal and interest.
-
Although investors in CMHC pass-through do not face default risk, they still face
prepayment risk.
o Prepayments are passed through to bondholders.
o If a default occurs, CMHC fully ‘prepays’ the bondholders.