Post by Admin/YBB on Mar 23, 2021 21:18:04 GMT -6
BOND FACTORY is a strange term to use but it may be used for bond-dealers that take one kind of bonds and transform them into another kind of bonds through SECURITIZATION. They charge fees for "production" and may also retain "servicing" rights with fees. They are producers or manufacturers of STRUCTURED credits; they can also do servicing or that may be a 3rd party.
STRIPS. The simplest process is coupon stripping. For example, take a 30-yr Treasury bond and split it into 2 x 30 = 60 coupon payments and 1 principal payment. So, now there are 61 ZERO-COUPON bonds that can trade by themselves. Treasury issues are huge, so these pieces are also large, with the principal payment part being the largest.
STRUCTURED CREDITS
Another process is to assemble many similar bonds [in type, credit-quality, maturity/duration] in a bond pool. This ORIGINATING pool has its own characteristics as a whole in terms of credit-quality and duration. The pool's credit-quality may be mid-investment-grade [AA, A]. Now this bond pool can be sliced into TRANCHES with different features and credit-quality through a process called SECURITIZATION. Interest payments, principal payments [for MBS, ABS], prepayments may be distributed into tranches in an ordered/preferential way based on some assumptions/specifications. So, these tradable tranches #1, #2,...,#N [or, letter designations] can have manufactured/structured credit-ratings that range from AAA, AA,..., C. Notice that some tranches will have better credit-ratings than the originating pool itself [CREDIT ENHANCING] and others lower. Unusually, there will be tranche(s) with manufactured/structured AAA ratings while in reality there are now only 2 US companies with genuine AAA bond ratings [JNJ, MSFT]. Call it credit ALCHEMY or MAGIC! And Wall Street loves fees!!
Most of the time, this works fine. But let us see what can go wrong. The originating bond pool may have issues due to unscrupulous participants and/or dealers, so some of the bonds may not have proper characteristics for the pool. The economic assumptions made about the payments of principal and/or prepayments may turn out to be off the mark. An example would be a residential mortgage pool [RMBS] where if the mortgage rates fall, the prepayments from re-fi may be higher than modeled/assumed; or, if the mortgage rates rise, the prepayments from re-fi may be lower than modeled/assumed. Tranches may be affected differently from these changes and they may behave differently from what could be expected from their manufactured/structured credit-ratings. In an extreme case, the originating bond pool may be jeopardized due to unforeseen events, and may collapse, and then all of the tranches will also collapse, even those AAA-rated tranches. Think of a house of cards that can fall apart due to small external disturbances; or, in the meat industry, when all grades of meat have to be recalled if the producing herd was later found to be diseased. Bond market is aware of these risks and prices structured credits with appropriate SPREADS. If the originating pool was of commercial mortgages [CMBS], then the prepayments characteristics will change significantly as there are prepayment penalties for CMBS. Some CMBS may have had federal, state, local incentives at the issuance, and it may not be practical to re-fi them even with penalties. CMBS also tend to have shorter maturities [up to 10 years] compared to RMBS [up to 30 years]. So, RMBS and CMBS tranches will have different characteristics.
At one time, the bond-dealers involved collected their fees and off-loaded the entire pool/tranches into the market, and if problems were found later, there was nobody to be held accountable; the 3rd party servicers would disclaim any liability. But after the financial crisis [2008-09], the practice/regulation is for these bond-dealers to hold on to a small % of pool/tranches on their balance sheets, and there may also be claw-back/return provisions for defective bonds found in the originating pool within a short time. These measures provide for better accountability in the structured credit market.
INTEREST-ONLY [IO], PRINCIPAL-ONLY [PO]. Although structured credits, IO/PO deserve their own section. Originating MBS pools receive payments that consist of interest and principal. These can be split into interest-only and principal-only portions. Then, the interest amount is distributed in an ordered/preferential way only among the Interest-Only [IO] securities, and the principal amount only among the Principal-Only [PO] securities. If there are prepayments [more for RMBS, less for CMBS], those are applied in some assumed manner to the POs. Now consider that mortgage rates rise. Homeowners will delay re-fi, the life/duration of the IOs will extend and their values will rise dramatically. So, as mortgage rates rise, the value of IOs will rise. Let us repeat this most unusual feature of bond IOs: AS MORTGAGE RATES RISE, THE VALUE OF IOs WILL RISE. An easy way to restate this is that the IOs have NEGATIVE DURATIONS. As this feature is very unusual, let us go through the process when the mortgage rates fall: Homeowners accelerate re-fi, the life/duration of IOs shrink and their values fall dramatically; again note the negative duration effect. The IOs are highly volatile, actually unstable may be a better description but that is not used for obvious reasons. The POs behave more like the regular MBS pool with positive durations. The result is that a MBS pool of some positive duration has been split into IOs of negative durations and POs of positive durations. In addition, the risks of originating MBS pool going bad also exist and then the entire IO/PO structure is at risk. IOs are in high demand from riskier aggressive bond funds.
A TRADITIONAL bond fund has positive duration and its NAV will fall if the rates rise. An AGGRESSIVE bond fund's NAV may rise when rates rise and there are at least 3 ways that can happen - extensive use of IOs, use of lower-quality floating-rate/bank-loans [FR/BL], short positions in bonds [long positions contribute positive durations, short positions negative durations]. These strategies require highly skilled bond managers, but remember that if the managers are wrong on their bets, they may just get fired, but part of your money may be gone forever to money heaven - there will be no recovery or rebound from losses due to these aggressive strategies! Unfortunately, there is poor disclosure about these in bond fund holdings, and even if noted, it is hard to figure out details related to those; moreover, as these may be trading positions, the holding details may be hopelessly stale when published.
This is just a brief glimpse into the complex world of STRUCTURED/SECURITIZED credits with additional alphabet soup of CMO, CLO, CDO, CDS, etc. Term DERIVATIVES is also used but often that is more associated with things like futures and options; in general, a derivative security is any security derived from another.
ABS - Asset-Backed Security; CMBS - Commercial MBS; IO - Interest-Only security; MBS - Mortgage-Backed Security; PO - Principal-Only security; RMBS - Residential MBS, STRIPS - Separate Trading of Registered Interest and Principal of Securities.
TRIVIA. “Bond” being a famous last name [who hasn’t heard of James Bond?], I was curious if “Bond Factory” is being used in commercial context. A web search found Swiss alternative-investment company, S African real estate firm, Indian tea company, Italian clothing company, Irish legal & business services firm, etc. Of course, the use here is generic for financial instruments that are bonds.
STRIPS. The simplest process is coupon stripping. For example, take a 30-yr Treasury bond and split it into 2 x 30 = 60 coupon payments and 1 principal payment. So, now there are 61 ZERO-COUPON bonds that can trade by themselves. Treasury issues are huge, so these pieces are also large, with the principal payment part being the largest.
STRUCTURED CREDITS
Another process is to assemble many similar bonds [in type, credit-quality, maturity/duration] in a bond pool. This ORIGINATING pool has its own characteristics as a whole in terms of credit-quality and duration. The pool's credit-quality may be mid-investment-grade [AA, A]. Now this bond pool can be sliced into TRANCHES with different features and credit-quality through a process called SECURITIZATION. Interest payments, principal payments [for MBS, ABS], prepayments may be distributed into tranches in an ordered/preferential way based on some assumptions/specifications. So, these tradable tranches #1, #2,...,#N [or, letter designations] can have manufactured/structured credit-ratings that range from AAA, AA,..., C. Notice that some tranches will have better credit-ratings than the originating pool itself [CREDIT ENHANCING] and others lower. Unusually, there will be tranche(s) with manufactured/structured AAA ratings while in reality there are now only 2 US companies with genuine AAA bond ratings [JNJ, MSFT]. Call it credit ALCHEMY or MAGIC! And Wall Street loves fees!!
Most of the time, this works fine. But let us see what can go wrong. The originating bond pool may have issues due to unscrupulous participants and/or dealers, so some of the bonds may not have proper characteristics for the pool. The economic assumptions made about the payments of principal and/or prepayments may turn out to be off the mark. An example would be a residential mortgage pool [RMBS] where if the mortgage rates fall, the prepayments from re-fi may be higher than modeled/assumed; or, if the mortgage rates rise, the prepayments from re-fi may be lower than modeled/assumed. Tranches may be affected differently from these changes and they may behave differently from what could be expected from their manufactured/structured credit-ratings. In an extreme case, the originating bond pool may be jeopardized due to unforeseen events, and may collapse, and then all of the tranches will also collapse, even those AAA-rated tranches. Think of a house of cards that can fall apart due to small external disturbances; or, in the meat industry, when all grades of meat have to be recalled if the producing herd was later found to be diseased. Bond market is aware of these risks and prices structured credits with appropriate SPREADS. If the originating pool was of commercial mortgages [CMBS], then the prepayments characteristics will change significantly as there are prepayment penalties for CMBS. Some CMBS may have had federal, state, local incentives at the issuance, and it may not be practical to re-fi them even with penalties. CMBS also tend to have shorter maturities [up to 10 years] compared to RMBS [up to 30 years]. So, RMBS and CMBS tranches will have different characteristics.
At one time, the bond-dealers involved collected their fees and off-loaded the entire pool/tranches into the market, and if problems were found later, there was nobody to be held accountable; the 3rd party servicers would disclaim any liability. But after the financial crisis [2008-09], the practice/regulation is for these bond-dealers to hold on to a small % of pool/tranches on their balance sheets, and there may also be claw-back/return provisions for defective bonds found in the originating pool within a short time. These measures provide for better accountability in the structured credit market.
INTEREST-ONLY [IO], PRINCIPAL-ONLY [PO]. Although structured credits, IO/PO deserve their own section. Originating MBS pools receive payments that consist of interest and principal. These can be split into interest-only and principal-only portions. Then, the interest amount is distributed in an ordered/preferential way only among the Interest-Only [IO] securities, and the principal amount only among the Principal-Only [PO] securities. If there are prepayments [more for RMBS, less for CMBS], those are applied in some assumed manner to the POs. Now consider that mortgage rates rise. Homeowners will delay re-fi, the life/duration of the IOs will extend and their values will rise dramatically. So, as mortgage rates rise, the value of IOs will rise. Let us repeat this most unusual feature of bond IOs: AS MORTGAGE RATES RISE, THE VALUE OF IOs WILL RISE. An easy way to restate this is that the IOs have NEGATIVE DURATIONS. As this feature is very unusual, let us go through the process when the mortgage rates fall: Homeowners accelerate re-fi, the life/duration of IOs shrink and their values fall dramatically; again note the negative duration effect. The IOs are highly volatile, actually unstable may be a better description but that is not used for obvious reasons. The POs behave more like the regular MBS pool with positive durations. The result is that a MBS pool of some positive duration has been split into IOs of negative durations and POs of positive durations. In addition, the risks of originating MBS pool going bad also exist and then the entire IO/PO structure is at risk. IOs are in high demand from riskier aggressive bond funds.
A TRADITIONAL bond fund has positive duration and its NAV will fall if the rates rise. An AGGRESSIVE bond fund's NAV may rise when rates rise and there are at least 3 ways that can happen - extensive use of IOs, use of lower-quality floating-rate/bank-loans [FR/BL], short positions in bonds [long positions contribute positive durations, short positions negative durations]. These strategies require highly skilled bond managers, but remember that if the managers are wrong on their bets, they may just get fired, but part of your money may be gone forever to money heaven - there will be no recovery or rebound from losses due to these aggressive strategies! Unfortunately, there is poor disclosure about these in bond fund holdings, and even if noted, it is hard to figure out details related to those; moreover, as these may be trading positions, the holding details may be hopelessly stale when published.
This is just a brief glimpse into the complex world of STRUCTURED/SECURITIZED credits with additional alphabet soup of CMO, CLO, CDO, CDS, etc. Term DERIVATIVES is also used but often that is more associated with things like futures and options; in general, a derivative security is any security derived from another.
ABS - Asset-Backed Security; CMBS - Commercial MBS; IO - Interest-Only security; MBS - Mortgage-Backed Security; PO - Principal-Only security; RMBS - Residential MBS, STRIPS - Separate Trading of Registered Interest and Principal of Securities.
TRIVIA. “Bond” being a famous last name [who hasn’t heard of James Bond?], I was curious if “Bond Factory” is being used in commercial context. A web search found Swiss alternative-investment company, S African real estate firm, Indian tea company, Italian clothing company, Irish legal & business services firm, etc. Of course, the use here is generic for financial instruments that are bonds.