Standard Fixed-Rate Features
Fixed-rate debt securities have fixed interest rates and fixed maturities. If held to maturity, they offer the benefits of preservation of principal and certainty of cash flow. Prior to maturity, however, the market value of fixed-rate securities fluctuates with changing interest rates. In a falling-rate environment, market values will rise, with the degree of increase determined by the time remaining to maturity or call date, creating the potential for capital gains. In a rising-rate environment, prices will fall, creating the risk of loss when securities that have declined in market value are sold prior to maturity.
These structures give the issuer the right to redeem the security on a given date or dates (known as the call dates) prior to maturity. Essentially, an option to call the security is sold by the investor to the issuer, and the investor is compensated with a higher yield.
The value of the call option at any time depends on current market rates relative to the interest rate on the callable securities, the performance of assets funded with the proceeds of callable issues, and the time remaining to the call date. The period of call protection between the time of issue and the first call date varies from security to security. Documentation for callable securities usually requires that investors be notified of a call within a prescribed period of time.
Issuers typically exercise call options in periods of declining interest rates, thereby creating reinvestment risk for the investor. On the other hand, if an investor expects a security to be called and it is not, the investor faces an effective maturity extension that may or may not be desirable. Certain securities may be called only in whole (i.e., the entire security is redeemed), while others may be called in part (i.e., a portion of the total face value is redeemed) and possibly from time to time as determined by the issuer.
The three most common callable features are:
- European—callable only at one specific future date;
- Bermudian—callable only on interest payment dates; and
- American—callable on any date, normally with 30 days notice.
In almost all cases, the right of the issuer to exercise a call is deferred to the end of an initial “lock-out period.”
The Valuation of Callable GSE Debt
When interest rates move, the values of almost all debt securities change. For non-callable fixed-rate instruments, the price of the security will go down as rates go up (and up as rates go down) so that yields remain in line with prevailing market rates.
For securities with embedded options, however, the market price also has to account for the change in the value of the embedded option. A call option, for example, becomes more valuable to the issuer as interest rates fall and the yield to investors adjusts to reflect that higher value. The degree of such shifts, however, may be difficult to determine accurately in advance. Market volatility will also affect the price investors are willing to pay for a given security.
Several valuation methods are available to help investors calculate the value of a specific debt security. Results can vary widely from model to model. While no single valuation method is universally preferred, some are used more commonly than others.
The option-adjusted spread (OAS), for example, calculates the annual value of an embedded call option (in basis points, based on an assumed rate of volatility) and subtracts it from the security’s yield spread. This adjusted spread can then be compared to the available spread on a non-callable security of similar credit quality with the same maturity. If the callable GSE security’s adjusted spread is less than the yield on a non-callable GSE security, the non-callable security may be a better investment choice.
The current calculations of the OAS on most outstanding GSE structured debt securities are available through leading information vendors.
Other approaches involve comparing the risk/reward profile of the security to that of other securities; performing a forward-rate analysis, which assumes forward rates will reflect current yield curve assumptions; reviewing the range of performance possibilities based on historical distribution of interest rates or under a stress scenario (e.g., a 200-basis-point shift in the yield curve); and calculation of an instrument’s internal rate of return.
An initial fixed interest rate is paid until a specified date, generally a call date. On a five-year note, for example, the call date may be two years after issuance. On the prescribed date, if the security has not been called, the interest payment “steps up” to a specified higher rate that was fixed prior to the issuance of the security. A single security can have more than one step-up period.
Step-up securities are typically structured so that they are callable by the issuer at any interest payment date on or after the first call, or step-up, date. Some step-up securities have been issued so that they are continuously callable after the first call date, meaning they can be called at any time, not just on the payment dates.
A less common variation is the step-down security, also callable, which provides the investor with a higher initial interest rate but greater uncertainty about maturity.
Indexed Amortization Notes
(IANs; also known as Indexed Principal Redemption Bonds, Principal Amortization Notes or Indexed Sinking-Fund Debentures.) These securities pay a fixed rate of interest and repay principal usually according to an amortization schedule which is typically linked to the level of a designated interest rate index such as the three-month U.S. dollar London Interbank Offered Rate (LIBOR). The amortizing principal payments usually begin at the end of a prescribed “lock-out” period.
For example, a five-year IAN might have a two-year lockout period during which interest is paid on the full principal amount. Between years three and five, investors receive partial repayments of principal, at an amortization rate determined by the designated index, and interest based on the amount of principal still outstanding. At the stated maturity date, any outstanding principal is retired regardless of the level of the index.
Factors That Affect the Price of Fixed-Income Securities
Fixed-rate capital securities have certain risks in common with other fixed-income securities. These risks affect the market price of the securities, which in turn affects their yield. In general, investors demand higher yields to compensate for higher risks. The risks of fixed-income securities include:
Interest Rate Risk The market value of the securities will be inversely affected by movements in interest rates. When rates are rising, market prices of existing debt securities will fall, as demand increases for new-issue securities with the higher rates. As prices decline, yields are brought into line with the prevailing rates. When rates are falling, market prices will rise, because the higher rates on outstanding debt securities will be more valuable. Here, too, the market works to align the yields with prevailing rates. Downward trends in interest rates also create reinvestment risk, or the risk that income or principal repayments will have to be invested at lower rates. Reinvestment risk is an important consideration for investors in “callable” securities.
Credit Risk The safety of a fixed-income investor’s principal depends on the issuer’s credit quality and ability to meet its financial obligations. Issuers with lower credit ratings usually have to offer investors higher yields to compensate for the additional credit risk. A change in either the issuer’s credit rating or the market’s perception of the issuer’s business prospects will affect the value of its outstanding securities.
Purchasing Power Risk Fixed-income investors often focus on the real rate of return, or the actual return minus the rate of inflation. Rising inflation has a negative impact on real rates of return, because inflation reduces the purchasing power of the investment income and principal.
Price Risk Investors who need access to their principal prior to maturity have to rely on the available market for the securities. Although investors in fixed-rate capital securities may take advantage of the exchange listing for retail offerings to sell their shares prior to maturity, the price received may be more or less than the purchase price as a result of these dynamic risk factors.