Security Descriptions

Treasuries

Treasury securities are backed by the full faith and credit of the United States government, and thus have the lowest degree of credit risk available to the investor. Because of the low degree of credit risk, investors are willing to accept a lower implied rate of return, or yield, on Treasury securities than on other securities with greater credit risk. The prices and yields at which Treasury securities trade provide a benchmark for most of the other debt securities traded in the United States.

Another characteristic of Treasury securities that makes them attractive to some investors, but also decreases their yield relative to other securities, is their liquidity. Large amounts of Treasuries can be traded quickly and easily, with little impact on their price. This characteristic is important to investors who want to maintain the ability to access funds on short notice.

The Treasury Yield Curve

Treasury securities are issued with maturities ranging from three months to thirty years. The Treasury yield curve represents a graph of the current yields of representative Treasury securities across the maturity range. The yield on these Treasuries is determined to a large degree by investors expectations of future interest rates. Higher levels of inflation and interest rates decreases the purchasing power, or value, of the investors cash flows from a security. To compensate for this loss of value, and investor will only be willing to purchase these future cash flows for a lower price, resulting in a higher yield on the security.

The Treasury yield curve is typically positively sloped, with investors demanding a greater yield for securities with a longer time to maturity than for those with a shorter time to maturity. This characteristic is due largely to the increased uncertainty that investors have regarding future interest rates; investors demand compensation for this increased uncertainty in the form of higher yields. There are times when the yield curve can become flat, or long term rates can actually fall below short term rates, but this typically happens only when investors expect future interest rates to be significantly lower than current rates, as in times of recession.

Mortgage Backed Securities

Mortgage backed securities are created when the holder of a group of mortgages (typically an agency or entity such as GNMA, FNMA, or FHLMC), pools the group and creates a security that can be traded in the secondary market. These securities are known as mortgage backed securities and each security is backed by a specified group of individual home mortgages. The holder of the security receives all of the principal and interest payments, including any prepayments of principal, made on each mortgage in the pool on a monthly basis. A small portion of the total coupon income is kept by the servicer who collects the individual mortgage payments on behalf of the security holder. Mortgage backed securities issued by the government entities listed above trade actively in the secondary market and are general highly liquid.

General Characteristics of Mortgage Backed Securitiess

The greatest difference between mortgage backed securities and more conventional bonds is the higher degree of uncertainty regarding the cash flows on mortgage backed securities. Because each individual mortgage holder in an MBS pool holds a call option on his mortgage loan (i.e., he has the ability to refinance, or call his current loan) the investor in a mortgage security has a greater uncertainty as to the ultimate timing of the cash flows on his investment. In mortgage backed securities, this call risk is typically referred to as prepayment risk, and has a significant effect on the ultimate return on the security.

Mortgage backed securities generally have less interest rate risk, and more reinvestment rate risk, than bonds with fixed semiannual interest payments due to the difference in cash flows to the investor on the two types of securities. Because mortgage backed securities pay interest monthly rather than semiannually, an investor receives interest roughly 30-90 days sooner than he would with a typical bond. In addition, the investor is receiving scheduled repayments of principal monthly, while the investor in a conventional bond would receive principal only at maturity. In addition to the scheduled monthly payments of principal and interest, the investor in a mortgage backed security may receive prepayments of principal for any mortgages in the pool that were refinanced or for mortgages that were paid off due to property sales or loan defaults, if the loan was covered by a government guarantee. All of these forms of accelerated cash flow serve to shorten the effective life of the security, and thus reduce the investors exposure to interest rate risk.

Market Risk/Volatility

The characteristics that contribute to the accelerated cash flow in mortgage backed securities relative to coupon bonds with similar maturities tend to result in reduced interest rate, or market risk for the investor in mortgage backed se curities. They usually show less of a change in value under various interest rate scenarios than coupon bonds with similar maturities.

Adjustable Rate Mortgage Backed Securities

The interest rate risk on a mortgage backed security can be further reduced by purchasing adjustable rate mortgage backed securities. These securities are comprised pools of mortgages that periodically reset the coupon interest rate paid by the mortga ge borrower. The most common type of the adjustable rate mortgage backed security is composed of mortgages that adjust every year at a spread of between 1.75% and 2.5% over a one year treasury security index. These mortgages typically have a periodic ca p of 2% per adjustment and 6% over the life of the loan.

Corporate Securities

Corporate securities represent obligations of corporate issuers to repay a principal amount, plus any stated interest, according to the schedule in the bond indenture. Corporate bonds are priced off of the Treasury yield curve, and their yield is often quoted as a spread over a comparable maturity Treasury bond. A single A rated corporate security with a five year term might trade at 53 basis points over the Treasury curve. This spread would give the corporate bond a yield of 6.70% if the five year Treasury was at 6.17%. A corporate bond with the same maturity, but a lower credit rating, would trade at a yield higher than 6.70%, while a corporate bond with the same maturity, but a higher credit rating, would trade at a yield closer to that of Treasuries. Credit risk usually plays a significant role in the returns on corporate securities. Corporate bonds may be secured by specific property or equipment, such as a factory building, aircraft, or railroad cars. Corporate bonds that are not secured by any specific asset of the company, but are general corporate obligations and are usually referred to as debentures. Corporate securities may also have call provisions that allow the issuer to retire some or all of the bonds prior to their stated maturity date.

Municipal Securities

Municipal bonds are issued by state and local governments or their authorities. Municipal bonds tax free status makes them attractive to the issuers because they are a low cost source of financing, while they are attractive to investors because the interest on the bonds is exempt from Federal taxes. Because of the tax free status of the interest payments, investors are willing to accept lower yields on municipal bonds than on other comparable taxable bonds. The major purchasers of municipal bonds are individuals in high tax brackets, insurance companies, and commercial banks.

The two major types of municipal bonds are general obligation bonds and revenue bonds. General obligation bonds are supported by the taxing authority of the issuing district. Revenue bonds are funded through revenue from the specific project being funded, which may be an airport, bridge, tunnel, convention center, water treatment plant, etc.

As is common among other major bond categories, the types of municipal bonds in circulation include bonds with put and call provisions, variable rate structures, and zero coupon bonds. Many municipal bonds carry credit ratings issued by one of the major credit rating agencies.

Small Business Administration (SBA) Securities

Small Business Administration securities are made up of groups of business loans that are originated by financial institutions and then sold, pooled and issued as securities in the secondary market with United States government guarantees covering the full principal amount of the loans. The loans may be fixed or adjustable rate, with the adjustable rate loans indexed to the prime rate. The adjustable rate loans adjust either monthly or quarterly.

A government designated servicing agent acts as a record keeper for the pools and passes trough to the bondholders all principal and interest payments. Because the bonds are backed by loans that make monthly principal and interest payments, SBA pools can be analyzed, and behave in a similar fashion to, mortgage backed securities. The timing of the return of the cash flows to the investor, or the prepayment speed, has a significant effect on the return. For securities purchased at a discount to par, increased prepayments increase the return to the investor; for securities purchased at a premium, increased prepayments decrease the return to the investor.