Source: The Bond Market Association
Agency CMO: Collateralized Mortgage Obligations backed by government-sponsored pass-throughs. See “CMO”
Agency MBS: An MBS issued and guaranteed by a government agency such as FNMA, FHLMC, or GNMA.
ABS (Asset-backed Security): A security backed by a pool of consumer or commercial receivables. Term not usually used to refer to standard MBS, even though MBS are technically asset-backed securities. Auto loans and credit-card receivables are the most common form of collateral for asset-backed securities.
Alpha: A measure of an investment manager’s ability to produce returns generated through active management techniques (i.e., choosing investments that will outperform the market in a given time period).
ARM (Adjustable-Rate Mortgage): A mortgage loan on which interest rates are adjusted at regular intervals according to predetermined criteria. An ARM’s interest rate is tied to an objective, published interest rate index.
Advance Refunding: A financing structure under which new bonds are issued to repay an outstanding bond issue prior to its first call date. Generally, the proceeds of the new issue are invested in government securities, which are placed in escrow. The interest and principal repayments on these securities are then used to repay the old issue, usually on the first call date.
Amortization: Liquidation of a debt through installment payments.
Average Life: On a mortgage security, the average time to receipt of each dollar of principal, weighted by the amount of each principal prepayment, based on prepayment assumptions.
Beta: The extent to which investments move with the market providing passive returns. In other words, the performance attributed to the rise and fall of the overall market.
BP (Basis Point): 1/100th of 1 percent; e.g., if a security yields 150 basis points over Treasuries, and Treasuries yield 6%, the security yield is 7.5%.
Call Price: The specified price at which a bond will be redeemed or called prior to maturity, typically either at a premium (above par value) or at par.
Call Risk: The risk that declining interest rates may accelerate the redemption of a callable security, causing an investor’s principal to be returned sooner than expected. As a consequence, investors may have to reinvest their principal at a lower rate of interest.
Cap: In the interest rate derivatives market, an instrument in which the buyer receives payments from the seller in the event interest rates rise above a specified level; used by the buyer as a hedge against rising interest rates. In the bond market, the cap of a floating-rate security is its maximum possible interest rate. See “Floor”
Carry: The cost of borrowing funds to finance an underwriting or trading position. A positive carry happens when the rate on the securities being financed is greater than the rate on the funds borrowed. A negative carry is when the rate on the funds borrowed is greater than the rate on the securities that are being financed.
CMO (Collateralized Mortgage Obligation): A multiclass bond backed by a pool of mortgage pass-through securities or mortgage loans.
COFI (Cost of Funds Index): A bank index reflecting the weighted average interest rate paid by savings institutions on their sources of funds. There are national and regional COFI indexes.
Convexity: The tendency of the price movement of a security to accelerate as it appreciates. Positively convex securities experience accelerated price action as they appreciate, while negatively convex securities experience dampened price action as they appreciate. The negative convexity of many MBS is one of the critical risk factors that must be hedged.
Credit Ratings: Designations used by ratings services to give relative indications of credit quality.
Credit Spread: A yield difference, typically in relation to a comparable US Treasury security, that reflects the issuer’s credit quality. Credit spread also refers to the difference between the value of two securities with similar interest rates and maturities when one is sold at a higher price than the other is purchased.
CUSIP (Committee on Uniform Security Identification Procedures): Established under the auspices of the American Bankers Association to develop a uniform method of identifying municipal, government, and corporate securities. CUSIP numbers are unique nine-digit numbers assigned to each series of securities.
Default: Failure to pay principal or interest when due. Defaults can also occur for failure to meet nonpayment obligations, such as reporting requirements, or when a material problem occurs for the issuer, such as a bankruptcy.
Default Risk: Possibility that a bond issuer will fail to pay principal or interest when due.
Duration: A measure of the price variability of a security relative to changes in interest rates. For a given change in interest rates, high (or long) duration instruments experience large price changes, whereas low (or short) duration instruments experience small price changes. Duration is the most basic risk factor of a security in determining a hedge.
Fixed-Rate Mortgage: A mortgage featuring level monthly payments, determined at the outset, which remain constant over the life of the mortgage.
Floater: A bond whose coupon varies as interest rates change, usually resetting at a spread over a market index such as LIBOR.
Floor: In the interest rate derivatives market, an instrument in which the buyer receives payments from the seller in the event interest rates decline below a specified level; used by the buyer as a hedge against falling interest rates. In the bond market, the floor of a floating-rate security is its minimum possible interest rate. See “Cap”
FHLMC (Federal Home Loan Mortgage Corporation): GSE Freddie Mac
FNMA (Federal National Mortgage Association): GSE Fannie Mae
GNMA (Government National Mortgage Association): GSE Ginnie Mae
GSE (Government Sponsored Entities): A group of financial services corporations (i.e., Fannie Mae, Freddie Mac, Ginnie Mae) created by the United States Congress. Their function is to reduce interest rates for specific borrowing sectors of the economy, farmers, and homeowners.
Hedge: For a security or portfolio of securities, offsetting trading positions designed to mitigate the risks associated with the securities.
Interest Rate Derivative: An instrument whose value and payments are determined by, and often extremely sensitive to, levels in interest rates. It usually takes the form of a contract between an investor and a dealer. Typical interest rate derivatives include swaps, caps, and floors.
Interest Rate Process: A mathematical model, which creates a multitude of possible interest rate scenarios, which are then used for the evaluation of, fixed income securities. With an interest rate process, the performance and risk of securities can be calculated and compiled over a wide range of possible scenarios.
Inverse Floater: A variable-rate bond whose coupon resets in the opposite direction of interest rates, according to a formula involving a market index such as LIBOR. A typical formula might be: 18% - 2x LIBOR, in which case the coupon would decline by 2% if LIBOR increases by 1%.
Investment Grade: Bonds considered suitable for preservation of invested capital; ordinarily, those rated Baa3 or better by Moody’s Investors Service, or BBB- or better by Standard & Poor’s Corporation. See “ratings”
IO (Interest Only): A mortgage-backed security whose payments derive exclusively from the interest payments on the underlying mortgages. Unexpected prepayments or defaults impair the value of IOs, curtailing payments of interest on the mortgages. See “PO”
Leverage: The use of borrowed money to increase investing power.
LIBOR (London Interbank Offered Rate): The interest rate at which major international banks in London lend to each other.
Liquidity: The ability to trade bonds efficiently without causing any major changes in their prices.
Long: Securities that are owned by a dealer or investor.
LTV: Loan-to-Value ratio.
MBS (Mortgage-Backed Security): A security whose payments are derived from payments on residential or commercial mortgages.
MBS Derivative: A mortgage-backed security with concentrated risk relative to one or several of the typical MBS risk factors: prepayment risk, interest rate risk, volatility risk, or default risk.
Non-Agency MBS: An MBS neither issued nor guaranteed by a government agency.
Non-Investment Grade: Bonds not considered suitable for preservation of invested capital; ordinarily, those rated Baa3 or below by Moody’s Investors Service, or BBB- or below by Standard & Poor’s Corporation. Bonds that are non-investment grade are also called high-yield bonds.
OAS (Option-Adjusted Spread): The average spread over the AAA spot curve, based on potential paths that can be realized in the future for interest rates. The potential paths of the cash flows are adjusted to reflect the options (puts/calls) embedded in the bond.
OTC Market (Over-the-Counter Market): A securities market that is conducted by dealers throughout the country through negotiation of price rather than through the use of an auction system as represented by a stock exchange.
PAC (Planned Amortization Class): A CMO tranche structured to be insulated from prepayment variability for a specified range of prepayment speed. Other tranches, known as support tranches (or companions), absorb most of the prepayment variability.
Par: Price equal to the face amount of a security; 100%.
Pass-through: An MBS in which principal and interest payments by homeowners are passed through as principal and interest payments to security holders.
Performance: An investment’s return (usually total return), compared to a benchmark that is comparable to the risk level or investment objectives of the investment.
Plain-Vanilla CMO: The most basic type of CMO in which all tranches receive regular interest payments, but principal payments are directed initially only to the first tranche until it is completely retired. Once the first tranche is retired, the principal payments are applied to the second tranche until it is fully retired, and so on.
PO (Principal Only): A mortgage-backed security that pays no coupon. Its payments derive exclusively from the principal payments on the underlying mortgages. Prepayments always enhance the value of POs. See “IO”
Point: Shorthand reference to 1%. In the context of a bond, a point means $10, since a bond with this reference means $1,000 (no matter what the actual denominations of the bonds of the issue). An issue or a security that is “discounted two points” is quoted at 98% of its par value.
Portable Alpha: A manager’s ability to improve alpha by investing in securities that are not correlated with the beta of an existing portfolio. See “alpha” and “beta”
Prepayment: The unscheduled partial or complete payment of the principal amount outstanding on a mortgage loan or other debt before it is due.
Prepayment Model: Model that attempts to describe the mathematical relationship between the level of interest rates and the level of prepayments. Prepayment models are usually based on statistical analysis of historical prepayment data, and are primarily used as inputs in valuation and hedging models (such as OAS models).
Prime Rate: Rate at which banks lend to their most favored costumers.
Prepayment Risk: The risk that falling interest rates will lead to heavy prepayments of mortgage or other loans, forcing the investor to reinvest at lower prevailing rates.
Put Bond: A bond that gives the holder the right to require the issuer or the issuer’s agent to purchase the bonds at a price, usually at par, at some date or dates prior to the final stated maturity.
Put Option: A put option allows the holder of a bond to “put,” or present, the bond to an issuer (or trustee) and demand payment at a stated time before the final stated maturity of the bond.
Rate Reset: The adjustment of the interest rate on a floating-rate security according to a prescribed formula.
Ratings: Alpha and/or numeric symbols used to give indications of relative credit quality. In the municipal market, these designations are published by the rating services. Internal ratings are also used by other market participants to indicate relative credit quality.
Redemption: The paying off or buying back of a bond by the issuer; also, repurchase of investment trust units by the trustee, at the bid price.
Reinvestment Risk: The risk that interest income or principal repayments will have to be reinvested at lower rates in a declining rate environment.
REMIC (Real Estate Mortgage Investment Conduit): A specific tax status for a mortgage-backed security issuance. Often used synonymously with CMO, since almost all CMOs are issued as REMICs.
REPO: Repurchase agreement; a borrowing mechanism whereby securities are posted as collateral for a loan. REPOs are technically structured as a sale of securities by the borrower to the lender, with a commitment by the borrower to repurchase at a later date. REPO is the most common form of borrowing used to leverage fixed income securities.
Scenario Analysis: Examining the likely performance of an investment under a wide range of possible interest rate environments.
Senior: Having a priority claim to cash flows (over subordinate tranches). In a CMO with default risk, senior tranches are the last to absorb credit losses.
Sequential CMO: The original CMO structure, consisting of a few tranches paying principal in sequence. Sequential tranches have less prepayment variability than support tranches, but more variability than PACs.
Short: Borrowing and then selling securities that one does not own, in anticipation of a price decline. When prices fall, the short is “covered” by buying the securities back and returning them to the lender.
Short Duration: Generally, debt which matures in one year or less. However, certain securities that mature in up to three years may be considered short-term debt.
Spread: (1) The difference between the price at which an issue is purchased from an issuer and that at which it is reoffered by the underwriters to the first holders. (2) The difference in price or yield between two securities. The securities can be in different markets, or within the same securities market between different credits, sectors or other relevant factors.
STRIPS (Separate Trading of Registered Interest and Principal of Securities): The Treasury Department’s program under which eligible securities are authorized to be separated into principal and interest components, and transferred separately. These components are maintained in book-entry accounts and transferred in TRADES (Treasury/Reserve Automated Debt Entry System).
Subordinate: Having lower priority to cash flows (relative to senior tranches). In a CMO with default risk, subordinate tranches are the first to absorb credit losses.
Swap: A transaction in which an investor sells one security and simultaneously buys another with the proceeds, usually for about the same price and frequently for tax purposes.
Tranche: An individual bond in a CMO structure. See “CMO”
Transparency: The concept of disseminating price, volume and other information to the public about transactions in the municipal market.
Volatility: A statistical measure of the variance of price or yield over time. Volatility is low if the price does not change very much over a short period of time, and high if there is a greater change.
WAC (Weighted Average Coupon): The weighted average interest rate of the underlying mortgage loans or pools that serve as collateral for a security, weighted by the size of the principal loan balances.
WALA (Weighted Average Loan Age): The weighted average number of months since the date of the loan origination of the mortgages in a mortgage pass-through security pool issued by Freddie Mac, weighted by the size of the principal loan balances.
Whole Loan: A mortgage loan that has not been insured or guaranteed by a government agency. Typically these include “jumbo” (high-balance) mortgages.
Whole Loan CMO: A CMO backed by whole loan collateral.
Yield Curve: The graphical relationship between yield and maturity among bonds of different maturities and the same credit quality. This line shows the term structure of interest rates.
Yield Spread: The difference in yield between two bonds or bond indexes.