Fixed Income Structured

Fixed Income — Structured Products

Core Concepts

MBS Pass-Throughs

A pool of mortgages whose cash flows (principal, interest, prepayments) are passed through to investors on a pro-rata basis. Agency MBS (Ginnie Mae, Fannie Mae, Freddie Mac) carry a government or GSE guarantee against credit losses, isolating prepayment risk as the primary concern. Non-agency MBS lack this guarantee and carry both credit and prepayment risk.

Prepayment Risk

Borrowers can refinance when rates drop, returning principal early. This creates negative convexity — when rates fall, MBS prices rise less than comparable Treasuries because prepayments accelerate and shorten the bond's effective life. Prepayment risk has two faces:

Contraction risk: Rates fall, prepayments accelerate, duration shortens. Investors receive principal back when reinvestment rates are lower.

Extension risk: Rates rise, prepayments slow, duration extends. Investors are locked into below-market coupons for longer than expected.

PSA Prepayment Model

The Public Securities Association model provides a benchmark prepayment speed:

100% PSA = ramp from 0% CPR to 6% CPR linearly over the first 30 months, then constant at 6% CPR thereafter.

At 150% PSA, all speeds are multiplied by 1.5 (e.g., the plateau is 9% CPR). At 200% PSA, the plateau is 12% CPR.

CPR and SMM

CPR (Conditional Prepayment Rate): Annualized prepayment rate as a percentage of the remaining pool balance.

SMM (Single Monthly Mortality): Monthly prepayment rate.

SMM = 1 - (1 - CPR)^(1/12)

Weighted Average Life (WAL)

WAL = sum(t × Principal_t) / Total Principal. Unlike maturity, WAL accounts for the timing of principal repayments (both scheduled and prepayments). WAL is shorter than maturity for amortizing securities and is sensitive to prepayment assumptions.

CMO Tranches

Collateralized Mortgage Obligations redistribute MBS cash flows into tranches with different risk profiles:

Sequential pay: Principal flows to the first tranche until retired, then the second, etc. Earlier tranches have shorter duration, later tranches have longer duration.

PAC (Planned Amortization Class): Provides a predictable principal schedule within a band of prepayment speeds (e.g., 100-250% PSA). Stability comes at the expense of companion/support tranches that absorb prepayment variability.

Support/Companion tranches: Absorb excess or deficit prepayments to protect PAC tranches. Highly volatile duration.

ABS (Asset-Backed Securities)

Securitized pools of non-mortgage assets:

• Auto loans: amortizing, relatively predictable cash flows
• Credit cards: revolving, with a revolving period followed by a controlled amortization period
• Student loans: longer duration, income-driven repayment creates uncertainty

CLOs (Collateralized Loan Obligations)

Tranched portfolios of leveraged loans (typically 150-250 loans). AAA tranches benefit from significant subordination (30-40% of the structure below them). Equity tranches receive residual cash flows after all senior tranches are paid. Waterfall tests (overcollateralization and interest coverage tests) redirect cash flows to protect senior tranches when the portfolio deteriorates.

Waterfall Structure

Cash flows are distributed by seniority: senior tranches receive interest and principal first, mezzanine next, equity last. If pool performance deteriorates, lower tranches absorb losses first (subordination protects senior tranches). Overcollateralization (OC) tests and interest coverage (IC) tests trigger cash flow diversions when breached.

OAS for Structured Products

OAS is essential for MBS because it captures prepayment optionality. Standard modified duration is inappropriate for MBS — use effective duration (computed via OAS models) or empirical duration. Monte Carlo simulation of interest rate paths and corresponding prepayment responses is the standard valuation approach for MBS.