Look for bonds with backing

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By Doug Awad

When you lend money to someone you want some assurance from the borrower that the debt will be repaid. You get that assurance by knowing whether and how a bond is secured, or backed.

In some cases bonds are backed by a legal claim on specific assets that can be forfeited to the lender if the debt is not repaid. One of the most common examples of s secured bond is a mortgage.

Your mortgage is secured by a lien against your house. If you don’t make your mortgage payments, the lender has the legal right to the house. The house serves as collateral for the mortgage.

Asset-backed bonds: Some bonds are actually backed by other debt. For example; asset-backed bonds are secured by assets that represent a regular stream of revenue or accounts receivable owed to a business.

Such assets include payments on home equity loans, auto loans (certificates for automotive receivables, or CARS), credit card debt, and consumer or student loans. A company that holds such debt, for example, a company that makes auto loans sells those loans to what’s called a special purpose vehicle.

The SPV, which might be a corporation, a trust, or some type of partnership, pools and repackages some or all of them into new asset-backed bonds. Those bonds then can be sold on the open market by broker-dealers.

The collateral for each of these bonds is the payment on the underlying auto loans. The process of creating a new security from a collection of other loans is called securitization.

Asset-backed bonds are most frequently bought by institutional investors, though the minimum denomination of $1,000 means that they also are affordable to individuals. Asset-backed bonds are generally highly rated because the bonds creators usually over collateralize them – there are usually more loans than necessary to make the bon’s interest payments.

Collateralized bond obligations: CBOs work in the same way as asset-backed bonds. However, the pooled assets that secure the bond typically are corporate high-yield (junk) bonds instead of business receivables.

Some CBOs, based on investment grade bonds, have been introduced. Also, even though the underlying bonds are pooled and used as collateral, the cash flow that the pool produces from the principal and interest on those bonds is sliced up into several tiers, or tranche (French word for slice).

Each trance is marketed separately, and is backed by multiple securities grouped according to their quality rankings. The highest (senior) tranche would be backed by the most highly rated underlying bonds.

Because of their higher quality, these tranches would offer the CBOs the lowest interest rate. The middle tranches (mezzanine) would include somewhat lower rated bonds and pay a higher interest rate.

The lowest (subordinated) tranches would be based on the riskiest underlying bonds and the interest on these would be paid only after the higher rated tranches have been paid.

Mortgage-backed bonds: A mortgage-backed security (MBS) is secured by mortgages instead of corporate bonds or revenue streams. In its simplest form, it is backed by an aggregated pool of mortgages, and passes a portion of all principal and interest paid on those mortgages directly to investors each month.

Pass-through securities: A Ginnie Mae is one example of what’s called a mortgage pass-through security.

Each Ginnie Mae security has only one class of security, and each investor has a direct interest in the underlying pool of securities. Payments of principal and interest are passed through to those investors.

What happens with that overall pool of mortgages affects each investor’s return in direct proportion to his or her share of ownership in the security. If mortgages in the group are paid off early because of refinance at a lower rate, that’s passed on in the monthly principal and interest payment.

This is known as what is a called prepayment risk –.the risk that such prepayments will reduce the yield when homeowners cut their interest rates or prepay their mortgages.

Fannie Mae and Freddie Mac also issue as well as guarantee pass-through securities. Ginnie Mae only adds its guarantee to privately issues pass-throughs that are backed by government insured (FHA and VA) mortgages.

Collateralized mortgage obligations (CMO): A collateralized mortgage obligation works something like a CBO. It groups many debt instruments – in this case mortgages – and pays out the CMOs investors the interest and principal owed on those mortgages.

The CMO is divided into tranches, each of which is marketed as a separate bond with its own interest rate, maturity, risk level, and sensitivity to mortgage prepayments. However the tranches are based not on credit ratings but on the estimated payment periods of the underlying mortgages.

For example; a CMO might have 2-, 5-, 10-, and 20-year tranches, though neither the rate of return nor the maturity date of the tranches is guaranteed. All payments of principal are paid to investors in the tranche with the shortest maturity until that tranche has been entirely retired. Principal payments are then directed to the next shortest maturity in sequence until all tranches are paid off.

Beyond this basic type, there are many different structures, each with its own prepayment characteristics. A CMO’s yield and average life will fluctuate depending on the actual rate at which mortgage holders prepay the mortgage underlying the CMO.

CMOs are issued by government-sponsored enterprises such as the Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac. CMOs are also offered by private issuers such as financial institutions and homebuilders.

If you have questions, call Doug Awad at 854-6866, or e-mail Doug.Awad@raymondjeames.com. He is a resident on the 200 Corridor and his office is on 31st Road, adjacent to Paddock Mall.

This information is partially developed by Forefield, Inc, an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security.

Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Assoc., Inc. does not provide advice on tax, legal or mortgage issues. These matters should be discussed with an appropriate professional.