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CFA Level II Chartered Financial Analyst Questions 23–27 (page: 66)

Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.

Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.


In his report, Wayne makes the following statements regarding the CMO:
Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.

Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.
Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.

Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.

Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.

Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.
Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:

Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.

Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.

Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.

Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.

Is Wayne correct or incorrect with regard to his analysis of debt service coverage and loan-to- value?

Wendall Wayne is a fixed income portfolio manager with Skyline Investments. Until recently he has focused almost exclusively on residential mortgage-backed securities (MBS). However, two weeks ago he was given approval to begin purchasing asset-backed securities (ABS) and commercial MBS as well. Wayne has forecasted that interest rates will decrease by approximately 100 basis points over the next month.

Wayne first completes an analysis of two tranches (a PAC I tranche and a support tranche) from a collateralized mortgage obligation (CMO) that was issued 18 months ago. When the CMO was issued, the initial collar of the PAC I tranche was 150 - 400 PSA. He estimates the change in the average life of each tranche as the prepayment speed varies, assuming the prepayment speed stays at that speed until the tranche matures. The results are shown in Exhibit 1.


In his report, Wayne makes the following statements regarding the CMO:
Statement 1: The CMO is structured so that the support tranche has more extension risk, and the PAC I tranche has more contraction risk.

Statement 2: The cash flows of the PAC I tranche will be less affected by the change in interest rates I have forecast than the cash flows of the support tranche.
Wayne has pushed for approval to begin trading ABS because he is particularly interested in collateralized debt obligations (CDOs). However, he doesn't know a lot about them, so he first does some reading and prepares some key points related to CDOs to guide his analysis.

Statement 3: CDOs are typically collateralized by emerging market bond issues, home equity bank loans, and high-yield corporate bond issues.

Statement 4: One advantage of issuing a synthetic CDO versus a cash CDO is that credit risk is lower with a synthetic CDO because the junior note holders also sell a credit default swap.

Statement 5: Some CDOs include an equity tranche to provide payment and credit protection to the senior and mezzanine tranches, but for most issues, credit protection is provided by external credit enhancements.
Wayne wants to understand the distinction between amortizing and non-amortizing assets that are securitized by ABS transactions, as well as the appropriate spread measures to use for various types of fixed-income securities. He asks a colleague, Martin Freed, to explain to him the difference between the two and how the payment structure of the ABS is affected by whether the assets in the pool are amortizing or non-amortizing. Freed replies:

Statement 6: An auto loan is an example of an amortizing asset, and a credit card receivable is an example of a non-amortizing asset.

Statement 7: For amortizing assets, the composition of the loans in the asset pool doesn't change once the assets are securitized. For non-amortizing assets, the composition of the asset pool does change.

Freed also tells Wayne that the credit analysis of commercial mortgage-backed securities (CMBS) should focus on the credit risk of the property, not the borrower. Freed also says that two key ratios useful for assessing the credit risk of the property are the debt service coverage ratio (net operating income/debt service) and the loan-to-value ratio (current mortgage amount/current appraised value). Wayne concludes that both of the ratios Freed recommends for credit analysis of CMBS are positively related to credit risk: the higher the ratio, the more risky the loan.

Finally, Wayne is trying to determine the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS. He plans to choose from the following measures: the zero-volatility spread, the OAS from the binomial model, and the OAS from the Monte Carlo model.

What is the most appropriate spread measure for valuing callable corporate bonds and high-quality home equity loan ABS?

Callable corporate bond Home equity loan ABS

Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.



At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.

As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:

Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.


Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.

Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.



Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.

Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.

If the spot-rate curve experiences a parallel downward shift of 50 basis points:

Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.



At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.

As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:
Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.
Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.

Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.


Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.

Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.
If the 5- and 10-year key rates increase by 20 basis points, but the 2- and 20-year key rates remain unchanged:

Natalia Berg, CFA, has estimated the key rate durations for several maturities in three of her $25 million bond portfolios, as shown in Exhibit 1.



At a fixed-income conference in London, Berg hears a presentation by a university professor on the increasing use of the swap rate curve as a benchmark instead of the government bond yield curve. When Berg returns from the conference, she realizes she has left her notes from the presentation on the airplane. However, she is very interested in learning more about whether she should consider using the swap rate curve in her work.

As she tries to reconstruct what was said at the conference, she writes down two advantages to using the swap rate curve:

Statement 1: The swap rate curve typically has yield quotes at 11 maturities between 2 and 30 years. The U.S. government bond yield curve, however, has fewer on-the-run issues trading at maturities of at least two years.

Statement 2: Swap curves across countries are more comparable than government bond curves because they reflect similar levels of credit risk.

Berg also estimates the nominal spread, Z-spread, and option-adjusted spread (OAS) for the Steigers Corporation callable bonds in Portfolio 2. The OAS is estimated from a binomial interest rate tree. The results are shown in Exhibit 2.



Berg determines that to obtain an accurate estimate of the effective duration and effective convexity of a callable bond using a binomial model, the specified change in yield (i.e., Ay) must be equal to the OAS.

Berg also observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.

Are the two observations Berg writes down after the fixed income conference advantages to using the swap rate curve as a benchmark instead of a government bond curve?