Fixed Income Recap

Treasuries rallied today as stocks sold off considerably. The two-year was up 6/32 of a point in price while the ten-year traded higher by more than two points as the benchmark curve was flatter on the day by 14 basis points. A basis point represents .01%.

TIC (Treasury International Capital System) flows for the month of December were released today showing that foreign investors may have the appetite to support Treasuries at these levels. The report showed net foreign purchases of U.S. Treasury bonds increased by $41 billion in the month of December. The looming increase in Treasury debt issuance is really controlling the market, so the large jump in prices today can be expected from news like this, even considering its lagging nature.

New issue MBS widened to comparable Treasuries today as mortgages underperformed the fast rallying ten-year Treasury. MBS widened thirteen basis points to +157 and 25 basis points wider from the twelve month low of +132 reached last week.

The Four Primary Risks of Bonds

Credit
Duration
Liquidity
Structure

The timing and order of cash flows generated from a bond is referred to as the bond’s structure. Investors have their pick from many different kinds of structure to fit their risk tolerance and overall investment strategy.

The most common bond structure is a simple bullet structure where the bond holder receives an interest payment every six months until maturity when the entire principal value is received at par. The interest income allows the investor to have cash for expenses or for reinvestment during the life of the bond. Most Treasury, corporate, agency and municipal debt is structured in this way.

Another common structure is the callable structure. One form of callable bond is very similar to the bullet structure except for a provision that gives the issuer the ability to pay back the principal before the bond matures. A callable bond will have a higher yield to maturity than a comparable bullet because of the added risk of the call structure. Issuers will often call bonds if rates have fallen and they are able to reissue the debt again at lower interest cost. Consequently, investors receive their principal back at a time when rates are low and reinvestment looks unattractive compared to before. Mortgage backed securities are partially called every month when the bonds pay principal from regularly scheduled mortgage payments and prepays resulting from the home being sold or refinancing. This leaves the investor with both interest income and principal to reinvest or spend.

Zero coupon bonds are issued at a discount, but mature at par, generating return for the investor without any interest payments. Although reinvestment risk isn’t as much of a concern with zero coupon bonds, delaying all of the return until maturity is also a risk. Zeros may be appealing for investors with no need for cash flow before maturity.

Another form of structure is credit structure. Some bonds are split up into sections called “tranches”, with each tranche having different exposure to credit risk. This form of structure is common among non-agency mortgage backed securities where defaults within the mortgage pool can be allocated to lower quality tranches first, in order to protect the higher quality tranches. Each tranche trades separately from the others, but their returns are often linked.

There is no best structure. The market prices the risks associated with each form of structure so investors must consider value along with their own needs for cash flow when choosing a structure. Diversification of structure, like other forms of risk, is important to any fixed income portfolio.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst