Saturday, November 05, 2011

Federal Issues


CFA Level 1 - Fixed Income Investments

Central governments can develop entities that issue bonds. These securities are referred to as semi-government bonds or government agency bonds. In the U.S. they are referred to as federal agency securities. 
The agency bond market can be further broken down into two categories:

1. Federally Related Institutions
Federally related institutions are arms of the federal government. They include Export-Import, Tennessee Valley Authority (TVA), Government National Mortgage Association (Ginnie Mae). With exception to TVA and the Private Export Funding Corp., these securities are backed by the full faith and credit of the U.S. Government.

2.Government Sponsored Enterprises (GSEs)
Government sponsored enterprises are privately owned, publicly chartered entities that were developed to help lower the cost of funding in certain sectors of the marketplace that the government feels are important enough to warrant assistance. 

They include the more familiar names such as:
  • Federal National Mortgage Association (Fannie Mae) - provides credit for the residential housing sector.
  • Federal Home Loan Mortgage Corporation (Freddie Mac) - provides credit for the residential housing sector.
  • Federal Home Loan Bank - provides credit for the residential housing sector.
  • Federal Agriculture Mortgage Corporation - provide credit for farm proprieties
  • Federal Farm Credit System - provide credit for agricultural part of the economy
  • Student Loan Marketing Association (Sallie Mae) -provides support for higher education.

GSEs issue two forms of debt: debentures are notes or bonds with typical maturities of one to 20 years, while discount notes are short-term papers with maturities ranging from overnight to 360 days.Fannie Mae and Freddie Mac, as noted above, provide credit and support for the housing sector. In doing so, they issue securities that are backed by the mortgage loans that they purchase. 

The loans act as collateral for the bonds and they come in three forms:

1.Mortgage Pass through Securities
Mortgage pass through securities are created when one or more bondholders form a pool (or collection) of mortgages and sell shares or certificates in the     pool. The cash flows depend on the payments of the mortgage and opens the investor to prepayment risk. The monthly cash flows include net interest, scheduled principal payments and any principal prepayments.

2.Collateralized Mortgage Obligations (CMOs)
CMOs are a derivative securities. They help an investor pick the type of cash flows he wants to be exposed to based on how the pool of mortgages are sliced up into tranches. The tranches offer investors different payment rules and par values. For example Tranche A might receive all principal payments until the balance is zero then the payments would flow to Tranche B and so on.

3.Stripped Mortgage-Backed Securities
For CFA exam purposes, just know that the name exists in case they want three examples of Freddie or Fannie.

Motivation Behind CMO Creation
The motivation behind creating a CMO is to spread the risk of prepayment among different classes of bonds. A CMO has several tranches that splits the mortgage pool into different layers. These layers have different par values and prepayment speeds. This aids investors in helping them manage the risk exposures they want in this arena.

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