Asset-Backed Securities (ABS) -Asset-backed securities are short-term investments that contain stable or certain cash flows that are, for example, backed by the payment streams from a variety of loans, leases, or credit card receivables. The first public offering of a security backed by an auto receivable was in 1985, while the first credit card receivable was floated in 1987. Over the last 12 years the ABS market has been the fastest growing segment of the short-end of the fixed income market. By 1998, total asset-backed issuance had surged to $280 billion. The explosion of the use of the asset backed market reflects in part the positive benefits available via the use of secured financing to lower funding costs and raise capital, especially in the consumer debt market. The overwhelming majority of asset-backed issues are AAA- or AA-rated due to the strong quality of the underlying collateral, the integrity of the payment structure, and the amount of additional credit support.
Asset-backed securities also provide a greater diversification than mortgage-backed securities due to the smaller loan balances and the greater number of consumer receivables. Asset-backed securities have become a major component of short-duration portfolios due to their short average life, high credit quality, and substantial yield enhancement above equivalent maturity U.S. Treasuries.
Bankers’ Acceptances -Bankers’ acceptances (BAs) are somewhat similar to bank commercial paper in that they are short-term, non-interest-bearing notes that are sold at a discount and redeemed by the accepting bank at full face value at maturity. However, BAs have a major technical difference. A commercial paper transaction is guaranteed by the issuing entity. Bankers’ acceptances provide added security in that the underlying goods or products that are financed back them. For the most part, BAs are issued as a byproduct of a foreign trade transaction and incorporate the use of a letter of credit issued against a specific set of imported goods. The big banks through which bankers’ acceptances are originated generally sell a portion of these acceptances into the market.
Certificates of Deposit -A certificate of deposit (CD) is a certificate issued by a bank that shows a specific amount of money has been deposited at the issuing institution. CDs are issued by banks to access funds for their finance and lending activities. The CD bears a specific maturity date, interest rate, and denomination.
CDs issued in amounts up to $100,000 are insured by the Federal Deposit Insurance Corporation (FDIC). A CD may be issued in either a negotiable or nonnegotiable form. Negotiable CDs provide the investor with the opportunity to sell the CD in the open market prior to the maturity date. CD yields are quoted on an interest-bearing basis, versus the discounted basis used for Treasury bills, commercial paper, and bankers’ acceptances. A CD with a maturity of one year or less posts interest income at maturity. In contrast, term CDs pay interest on a semiannual basis. The yield on CDs is higher than that on Treasury securities of the same maturity due to the credit rating of the issuing bank, the liquidity of the CD market, and the supply and demand for CDs.
Commercial Paper -Commercial paper (CP) is an unsecured promissory note issued by a corporation for a specific amount and maturing on a specific day that cannot be farther into the future than 270 days. The bulk of the CP issued is for maturities of less than two months. The original purpose of commercial paper was to provide funds for short-term seasonal and working capital needs. In recent years CP has been used for “bridge financing” for plant and equipment expenditures or to temporarily fund a corporate takeover. CP is typically rated by credit agencies that attempt to evaluate the liquidity, cash flow, profitability, and backup credit availability of the entity that is issuing the paper. The minimum lot transaction is $100,000, but most of the paper is bought in million dollar blocks.
Federal Agency Securities -Outside of the Treasury market, the federal agency market is the second most liquid market. These securities carry some form of direct or quasi government backing and can be divided into two sectors: federally sponsored agencies, more commonly called government-sponsored entities (GSEs) and federally related institutions. GSEs typically issue two types of securities: discount notes and debentures. The agency discount notes usually range in maturity from five days to 270 days, but some issues go out for as long as one year. The debentures carry maturities similar to U.S. Treasury notes and bonds. In the early 1980s the majority of the larger federal agencies issued straight noncall debentures in accordance to a set calendar issuance cycle similar to the Treasury auction cycle. In the early 1990s the Federal Farm Credit System, for example, issued six- and nine-month debentures for settlement on the first business day of the month, while longer-term coupon debentures were floated eight times a year at approximately six-week intervals. In recent years, through the expansion of the interest rate swaps and options market, many federal agencies float and redeem paper on an intra-day basis. The majority of these debentures is sold on a spread basis versus treasuries and may contain a variety of derivative features that can either enhance or reduce the total return to the investor. With the exception of securities issued by the Farm Credit Financial Assistance Corporation, GSE paper is not specifically backed by the full faith and credit of the U.S. government. Nonetheless, it is perceived that it would be highly unlikely that the federal government would allow one of its agencies to default on its obligations. However, while credit risk is limited the actual interest rate risk from these securities can be quite high. Callable agency paper is a potentially risky derivative product that requires sophisticated analysis to evaluate its embedded option features. Many colleges and universities have bylaws that allow them to invest in agency securities, but these rules were established many years ago, well before these agencies changed their issuance patterns from straight debentures to today’s program of largely derivative issuance. In order to evaluate the value of these securities, the proper tools must be available to assess the options-adjusted risk embedded in this product. Direct changes in interest rates and/or changes in current or future market volatility can have a dramatic impact on the overall returns and average life of these securities.
Floating-Rate Notes -The term floating-rate notes (FRNs) includes different types of securities with a similar feature that the interest rate or coupon rate is adjusted periodically to a benchmark or base rate. A simple example of a floating-rate instrument is a Series EE savings bond where the semiannual interest rate is determined in May and November based on 85 percent of the average market return of the five-year Treasury note for the preceding six months. In theory, floating-rate notes are securities with coupons based on a short-term rate index (such as the three-month Treasury bill or the three-month London InterBank Offered Rate or Eurodollar index (LIBOR) that is reset more than once a year). An adjustable-rate note or variable-rate note is a fixed-income security with coupons that are reset based on a longer index (i.e., the two-year Treasury note). Moreover, adjustable-rate notes are usually reset no more than once a year. Banks and financial institutions have been the largest issuers of variable-rate securities as these institutions attempt to match floating-rate assets with floating-rate liabilities.
Mortgage-Backed Securities (MBS) -During the last 15 years, mortgage-backed securities have been one of the fastest growing sectors of the fixed-income securities market. Mortgage-backed securities (MSB) have several unique characteristics, beginning with the payment of interest on a monthly basis. MBSs also differ from standard Treasury investments in that the cash flow pattern is uncertain due to the risk of prepayments or the unscheduled payment of principal. Moreover, a change in the future assumption for prepayments will also affect the rate of return on the investment of a mortgage-backed security. Mortgage-backed securities are created when mortgage pools are collateralized into interest-bearing securities. This securitization process can be accomplished via either a sale of assets or as a debt obligation of the issuer. In the former, a mortgage pass-through security is created, while in the latter case a mortgage-backed bond is originated. The collateralized mortgage obligation (CMO) was introduced in June 1983 and was a dynamic innovation that helped to eliminate some of the less desirable monthly interest payment and negative convexity elements of a traditional mortgage-backed security. A group of bonds issued in a CMO deal is called a tranche. The short maturity (one- to two-year average life), enhanced call protection, and conversion to semiannual coupon payments found on many CMO first tranches make them suitable for some operating and endowment cash accounts as either direct investments or as part of an outside managed portfolio.
Repurchase Agreements -A repurchase agreement (repo) is a collateralized transaction between a bank or nonbank dealer and an investor. Structurally, a repurchase agreement is the sale of a security with a commitment by the seller to buy back the security from the purchaser at a specified price and on a specified date in the future. The bulk of repo financing is done on an overnight basis and is called an overnight repo. However, a repo transaction can be set up for longer periods as well. One-week, one-month, and longer-term financing positions are called term repos. These longer maturity-financing positions should allow for a repricing of the vunderlying collateral as well as collateral substitution. The seller of a security in a repo agreement continues to receive all the coupon interest income, but will also be impacted by the changes in principal value on the security. The purchaser of a repo transaction receives a set rate of interest on the short-term investment. Repos are viewed as very safe investments because of the direct collateral lending link as well as the creditworthiness of the entity with whom the repo transaction is undertaken. Nonetheless, given the movement in market prices, many purchasers of repos ask for an over-collateralization of the transaction that equates to 102 or 103 percent of the face value of the securities that are on loan. The underlying securities in a term repo position should be repriced on a daily basis, with daily adjustments to collateral positions based on the change in the market’s price for the underlying security. If used properly, repo positions offer investors the opportunity to keep surplus working capital cash invested without facing liquidity, credit, or price risk.
However, maintaining an active repo book can be time consuming and can require a variety of safekeeping and security repricing capabilities. Moreover, the interest income derived from repo transactions is usually below other investment alternatives.
The Federal Reserve uses the repo market to implement monetary policy by purchasing or selling collateral (a reverse repo) with its primary dealers. If the Fed opts to buy collateral, it is in effect injecting funds reserves into the financial markets. If the Fed conducts a “matched sale” (a reverse repo), it is selling securities for its own account to drain liquidity from the financial markets. Accordingly, aggressive reserve shifts by the Fed could impact the supply and demand relationship of the repo market, which, in turn, could have an impact on short-term interest rates.
Treasury Securities -Treasury securities are investments issued by the Department of the Treasury that are backed with the full faith and credit of the United States government. Accordingly, Treasuries are viewed as having no default or credit risk. The U.S. Treasury market is the largest and most liquid securities market in the world. Treasury securities are issued in two different forms depending on the length of maturity. Those securities with an original issue maturity of one year or less are issued in a discounted form and are called Treasury bills (T-bills). These holdings are auctioned at a discount from face value and then, at maturity, are redeemed at par. The size of the discount at which a given Treasury bill is auctioned or traded and its time until maturity at par provide an implied yield for investors. Treasury securities of longer maturity are called Treasury notes or bonds.
During the exploding deficit period of the mid-1980s, government bond dealers began to clip the coupons of bonds and sell them as individual securities. In effect a T-bill-like structure was created for Treasuries with maturities from one to 30 years. These products took on “animal like” acronyms as each of the major dealers named its divided Treasury products after various felines. TIGRs, COUGARs, CATs, and LIONs paved the way for the Treasury’s own zero coupon bond product called Separate Trading of Registered Interest and Principal Securities, more commonly called STRIPS. Today, all new Treasury notes and bonds with a maturity of 10 years or longer are eligible for the Treasury’s zero-coupon STRIPS program. Many educational institutions use short-dated STRIPS to reinvest the proceeds of a bond financing against the payment schedule for a new building project that may take two to three years to complete. STRIPS solve the issue of the reinvestment of coupon interest and at times can be targeted to a specific payment structure.
However, this often comes at the expense of a reduction in the yield, as compared to alternative high-quality fixed-income instruments that are available with returns that are substantially higher than zero coupon bonds. Moreover, the liquidity of short-dated STRIPS is at times limited.
The Treasury yield curve is often viewed as the interest rate differential between Treasury issues from the three-month T-bill to the 30-year T-bond. Market participants will sometimes talk about the Treasury coupon yield curve, which represents the differential on the yield for securities from the current two-year note to the current 30-year bond. During most periods, the yield on U.S. government securities increases with maturity due to the time value of money and the increased inflation and interest rate risk parameters that exist for longer-dated Treasuries. This produces an upward sloping yield curve, which is also termed a normal yield curve. During selected periods when short-term rates are higher than long-term rates, the Treasury yield curve would be downward sloping, and is termed inverted.
In recent years inverted yield curves have taken place during periods of aggressive tightening by the Federal Reserve Board (Fed) to moderate inflation and occasionally just prior to the onset of a potential recession.