·
In naked eye MBS is always more attractive than a
corporate security simply because it has cover by a pool of assets. However
security of MBS depends upon the movement of such assets which is mortgage.
Hence Mortgage need to be intact for the period of maturity to provide security
to MBS. However due to expected fall in interest rate following risks always
involve which will make significant changes in mortgage and eventually to the
investor of MBS.
ü Prepayment Risk: - If market interest
rate decreases and its fall below the mortgage interest rate then this will
give a chance to borrowers to refinance their mortgage. If interest rate fall
borrowers are more likely to payout there mortgage principle in order to take advantage
of interest rate. However this situation is not as good for investor as he will
get his principle back sooner than expected has to invest it in a lower
interest rate which lead to lower value than that of if MBS holds its maturity.
In the given case client
is investing with a purpose that payout of this investment will be used for his
daughter college education. Now fall in interest rate will reduce maturity of
MBS. It means he do not have any payout from MBS at the time when he need money
for education of his daughter.
ü Contraction Risk: - It is a part of
prepayment risk. It is the risk that borrowers will pay back maturity value at
a faster rate than expected. This arises as a result of interest rate fall in
the market. If interest rate falls below rate of interest for mortgage,
borrower will accelerate payment of principle resulting to contraction.
ü Interest Rate Risk:- One of the most
attractive feature of MBS in this case is it has a higher interest rate as
compared to corporate bond resulting in more payout than corporate bond.
However if interest rate starts decreasing MBS will not have more payout simply
because it has lesser base capital as compared to corporate bond.
ü Increase in Bond Price: - If interest
rate decreases bond price will go up. This is because as interest rate falls
borrowing power and purchasing power of people goes up. This would result in
increase in demand for bond and eventually bond price will go up. This will
give investor a better opportunity.
Above
analysis revels that investing in MBS is very risky proposition over here. This
could lead to a situation where client does not have sufficient fund at
maturity to cover cost of education of his daughter. Hence, after considering
all aspect will recommend corporate bond for investment.
In this part we will talk about a new situation where a new CMO is issued
which is protected by a class A VADM tranche. Now it is to compare this new CMO
with the corporate bond recommended earlier. For this purpose this memo needs
to address following-
·
What is
VADM?
VADM is ‘very accurately defined maturity’ bonds. As the name
suggests this are bonds designed to payout at certain preselected times only. This
is similar to ‘planned amortization class’ (PAC) bond. PAC bond are used to
protect against extension and contraction risk associated with MBS. This will
cover extension risk at the time of rise in interest rate. Similarly this also
covers contraction risk at the time of fall in interest rate.
However payments of a VADM are supported in a different way as
compared to a PAC. In PAC payments are backed by a supported bond whereas in
VADM payments are supported by accretion of a Z bond. Z bond is just like zero
coupon bond.
·
Description
of New CMO tranche and its comparison with corporate bond recommended earlier-
Description of new CMO-
The new CMO is a AA-rated, 7-year Class A VADM tranche. This VADM tranche is
backed by a Z bond. Coupon rate of this VADM is 7% which is better than
corporate bond. CMO has a similar rating ‘AA’ and similar maturity terms as
compared to corporate bond. Features of this CMO-
1.
Protected against Z bond
2.
Higher interest rate of 7% as compared to
corporate bond
3.
7 years maturity (corporate also have same
maturity and client need money approximately at the same time)
Comparison with corporate bond-
Table showing comparison of CMO
with corporate bond
Security
|
Rating
|
Interest
Rate
|
Maturity
Period
|
Protection
|
Corporate
Bond
|
AA
|
6.75%
|
7 years
|
Not protected
|
CMO
|
AA
|
7.00%
|
7 Years
|
Protected against Z bond
|
VADM cover prepayment risk-
A CMO is collateralized mortgage obligation. It is always more
attractive as it is backed up a repackage of mortgage pool. However it
associates with extension risk and contraction risk. A VADM tranche is used to
reduce such risk. VADM use Z bond which are similar to zero coupon bonds. Interest
payable on a Z-bond is not paid at intervals instead it is added to the
principal balance and available for payable only on maturity. A Z-bond is
similar to a zero-coupon bond; hence it does payout at intervals and pay only
at maturity, so even if there is prepayment of mortgage investors is secured
against payment of Z bond, so even if there is prepayment of mortgage investors
are secured against payment of Z bond. A Z bond accrues interest rather than
paying it out. Therefore, the final tranche is considered the most risky for
the CMO class structures.
In the given case, new CMO is a AA rated 7 year VADM with 7%
coupon protected against a Z bond. Client need money for covering cost of
education of his daughter at maturity of this instrument. Hence he needs
protection. This CMO provides a better security to client as compared to
corporate bond. Actually this CMO has following benefits
ü
Extra return as compared to corporate bond
ü
Protection against prepayment and contraction
risk
Further this CMO has the same rating as corporate bond; hence
it has approximately same quality as corporate bond.
Considering the situation discussed above I recommend new CMO
for investment for this client.
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