1.1 EquitiesFootnote ¹

1.1.4 What are the downsides?

Once a company issues shares it is simply selling off some of its existing value. In other words, the ownership of the company is being diluted and previous stakeholders now own a much smaller portion. This also has the effect that the direction of the company will be impacted on by a larger group of investors, and the founders will have a diminished say in where the business is going.

The other potential disadvantage is that once a company issues stock to the public, its financial health is no longer a private matter. Public corporations must release financial statements and these often come under intense scrutiny. This can divert attention away from what matters (the business) to public opinion, given that one bad financial statement could send the shares plunging.

The screenshots below show how Marks & Spencer is capitalised.

Figure 1: The capital structure of Marks & Spencer [Source: Bloomberg]

Figure 2: The debt distribution of Marks & Spencer [Source: Bloomberg]

1.2 The primary market

Once a company decides to issue stock to the market, what happens and who is involved?

A private company coming to the market for the first time will prepare an IPO (Initial Public Offering). Additional shares issued after an IPO are called secondary offerings. Both offerings have several steps which need to be followed.

1.2.2 The balance sheet

The balance sheet provides a snapshot of a company's health. It measures at any given time how much a company owns (assets), how much it owes (liabilities) and how much equity its shareholders hold (shareholders' equity). The balance sheet will balance debts and shareholders' equity on one side, and assets on the other.

Figure 3: Financial analysis of a company [Source: Bloomberg]

1.2.3 The income statement

An income statement is a snapshot of business performance during a specific period of time (usually a quarter or a year). It measures how much a company made (revenue), and how much it spent (expenses), and from that how much was left (income). Income can be simply represented as Income = Revenue – Expenses.

Figure 4: Income statement summary for Marks & Spencer [Source: Bloomberg]

1.2.4 The cash flow statement

A cash flow statement focuses on one particular aspect of a company's performance in its history: the inflow and outflow of cash. The three main factors in a company's cash flow statement are:

• • Cash flow from operations

• • Cash flow from investing

• • Cash flow from financing

It is expressed as follows:

Figure 5: The cash flow statement from Marks & Spencer [Source: Bloomberg]

1.3 Secondary markets

Most stocks are listed on an exchange where prices are public and various market-players work together to ensure fair and orderly trading. The alternative is referred to as the OTC (Over the Counter) market.

There are many exchanges around the world and each exchange will have listing criteria, which is a set of guidelines stocks must meet in order to be able to trade on the exchange (for example, minimum market capitalisation; number of shares outstanding, etc).

Throughout the day trades are reported to the exchange in the form of bid and ask prices. The information is aggregated and the public can easily see the “best bid price” (the price at which people are willing to “buy” the stock) and the “best ask price” (the price at which people are willing to sell the stock).

In the OTC (Over The Counter) market there is no physical location for trading, instead dealers are linked by telephone or via systems such as Bloomberg and quote prices directly to each other.

2.1 Bonds

2.1.4 Yield

A bond's yield is the total return an investor earns on a bond expressed as a percentage.

You may think that a yield is simply the coupon under another name. After all the coupon is interest, and bonds are all about earning interest on a loan. But you have to take something else into consideration: Price

If we put bonds traded in a vacuum, all bonds would sell at face value, investors would hold them until maturity and the yield would be the coupon. But in reality investors sell bonds before they reach maturity. Therefore, during their lifetimes, bonds become inherently more or less valuable. This volatility is represented in the price.

Figure 6: A price graph of a Marks & Spencer bond, with a coupon of 5.625% maturing on 24 March 2014 [Source: Bloomberg]

The M&S bond may be selling for 100 today but it may be 110 tomorrow or even 90. Whatever the price, the coupon will remain the same. You are still going to receive your interest payments and the face value is going to stay the same. M&S will still pay out at maturity, but the amount you have to pay to receive that coupon and face value changes. You could pay 110 or 90 and still get the same payments in return. There is therefore a straightforward relationship between yield, coupon and price.

• • Yield  =  Coupon/Price

Price and yield are inversely related. As price goes up, yield comes down. As yields go up, prices go down.

Figure 7: The graph shows the inverse relationship. The bond price is in white. The bond yield is in grey.

2.2 Risk

Bonds can be risky too. During the sometimes long life of a bond several things can happen:

• • Issuers can face financial hardship and be unable to repay the loans

• • Other bonds can become more attractive, making yours less valuable

• • Cost of goods and services may rise, giving your bond returns less buying power

• • You could have trouble selling a bond you no longer want

• • Once your bond matures, you may have trouble finding an equally attractive investment

2.3 Why do governments issue bonds?

Governments clearly need money and although a lot is raised through taxation it is not nearly enough to fund the needs of a country. Governments will issue debt for three main reasons:

• • Finance the deficit. Governments usually spend more than they take in and to cover that gap rely on the influx of capital from the sale of bonds.

• • Fund ongoing operations. Bonds are used to pay for various projects. Tax receipts are sporadic in nature and the government will need funding on tap if there is not enough cash around at the time to pay certain bills.

• • Cover debt rollover. What does the government do when it needs cash to pay off its bonds? It simply issues more bonds in a never-ending cycle of debt issuance.

2.4 Why are government bonds so important?

In the financial market place government bonds are the closest thing to a “safe bet”. In countries where the government and economy are strong, there is extremely little risk of default. In fact such treasuries are said to represent a “risk free rate of return”. This is essential as it explains the relationship between risk and reward. The more risk you take, the higher you expect the reward to be. Government bonds are least risky, but in return they carry the least reward. Investors in less stable or riskier markets expect returns to be commensurate with their increased levels of risk. Government bonds are therefore used to measure what those returns should be. They act as a benchmark for other securities.

2.5 Why do companies issue bonds?

Companies who wish to fund on-going operations or expand into new product lines and markets need funding. In order not to relinquish ownership they are happy to issue bonds, particularly as loans from banks can attract high rates and the banks might not approve some of the loans required. A corporate bond is an agreement whereby the company agrees to pay interest on investors' initial investment over a specified period of time.

2.6 How are corporate bonds organised?

There are many different varieties of corporate bonds, and the task of evaluating a bond's “worth” can be daunting. So what do you look at?

Industry type: The classification of a bond based on the type of business an issuer is in plays an important role. An issuer in the financial sector faces far different risks than an issuer who is in the utilities sector, as has been seen by recent events in world financial markets. Bonds can be classified in broad sectors such as:

• Basic materials

• Communications

• Consumer, Cyclical

• Consumer, Non-cyclical

• Diversified

• Energy

• Financial

• Industrial

• Technology

• Utilities

2.7 Credit ratings

Unlike government bonds, corporate bonds are seen as riskier investments. In order to measure the riskiness of such investments, independent agencies will track the credit worthiness of bond issuers and assign credit ratings. The credit rating provides an answer to the question of “as an investor how likely am I to get my money back?”

Figure 8: The credit rating of a Vodafone Bond with a 5.75% coupon maturing on 15^th March 2016 [Source: Bloomberg]

2.8 Maturity

It is worth remembering that the greater the maturity the greater the risk. In order to value bonds and to make any analysis or comparison meaningful, groups of bonds with similar maturities should be compared. In the corporate bond market the categories are broken down as:

• • Short-term: mature in 1–5 years

• • Medium-term: mature in 5–12 years

• • Long term: mature in 12 or more years

When looking at one particular company it is important to know how many, and what type of bonds, it has outstanding, so as to understand how attractive it is relative to other potential bonds it has in the market. We saw this overview earlier with Marks & Spencer in terms of the company's total outstanding debt.

2.9 How are corporate bonds structured?

We have had a brief look at industry type, credit ratings and maturity as key characteristics but what about how issuers pay interest? The cashflow structure is one of the ways bond issuers can gain some flexibility in their debt repayment. Payments of interest can be fixed, variable or sometimes they come in a lump sum. Some bond issuers also structure their bonds so that the issuer has the right to call off the agreement before the maturity date. Such a redemption provision allows issuers more flexibility in how they repay their debt.

Coupon Structures

1. 1. Fixed coupon: Coupons are paid at a fixed rate throughout the life of the bond. This is a standard issue bond. So, if a bond pays a 5% coupon and the coupons pay out semi-annually, then the investor will expect to receive 2½% interest on the face value of the bond every six months.

2. 2. Floating: The coupon rate changes during the life of the bond. Usually the coupon rate is attached to a benchmark rate (such as LIBOR (The London Interbank Offered Rate fixed every morning at 11am by the British Bankers Association)).

3. 3. Zero coupon: The bond does not pay a coupon. Instead it is issued at a discount to par. The difference between the discount and par is the investor's return.

4. 4. Step (Multi): The bond pays a coupon at one fixed rate until a specified date, at which point the rate rises or falls to a new fixed rate. This new rate is specified at issuance.

3.1 The process of securitisation

Securitisation through issuing asset-backed or mortgage-backed bonds gives companies (mainly banks and building societies) an alternative way of borrowing in the bond market. The reason for this is that they are thus able to remove risk from their books (liquidate their assets) whilst also borrowing at a cheaper rate.

The process will be explained for both the US and the European markets.

3.2 European securitisation model

Figure 9: European securitisation model

In the model below, the consumer borrows a lump sum (principal) from the mortgage lender (e.g. Abbey National/Lloyds/Barclays etc) to be able to afford to buy a property. In return, that homebuyer must pay the mortgage lender a monthly interest payment (fixed or floating) and also a certain percentage of the initial principal, thus paying off the amount lent whilst also paying the interest as a form of profit for the mortgage lender.

However, the lender does not wish to have to wait 20/30 years for the value of the full principal to be repaid. This is because:

• • They may have large amounts of debt on their books and are thus highly leveraged (greatly exposed to a high level of risk of default/credit risk) and they would rather transfer the risk from their books.

• • The large debt on their books not only means they have a high credit risk, but this in turn affects their rate of borrowing. If they have greater risk exposure, then their rate of borrowing money will increase, thus negatively affecting their profits. Removal of this risk is desired in order to produce cheaper borrowing rates.

• • If they remove the risk and future cash flows in return for a lump sum principal from the investment bank, then they have the initial principal and a profit, and can begin lending again. This allows them to re-start the cycle and thus have more profitable opportunities.

The lender packages together the mortgages lent out (using characteristics such as term, credit quality, and geographic location) into what is known as a Pool. These pools are then sold to the investment bank for the above reasons for the principal sum. The investment bank will then securitise these pools into mortgage-backed securities/collateralised mortgage obligations, etc and structure them in the manner shown below in order to make the Pool, and thus the MBSs within it, as viable and attractive for the market to buy into as possible.

Once the pool is structured in the necessary way, it is ready to be issued into the market, but again the investment bank (in the same way as for the lender) does not wish to have the risk exposure and debt on its books, whilst also not wishing to be associated with those MBSs. Therefore, an independent, bankruptcy-remote shell of a company, called an ‘SPV’ (Special Purpose Vehicle), is created and this body issues the bonds into the market. It is located in a tax haven and has no assets at all, so cannot be claimed upon in the event of a default of the bonds. The ‘SPV’ is associated only with the lender itself (for example ‘Granite’ SPV, which takes its name based on its Lender “Northern Rock”. In the same way Northern Rock has other SPVs, such as ‘Dolerite’, ‘Graphite’ and ‘Whinstone’).

Having been issued, the bonds can be actively traded and in the event of any default, neither the SPV (no assets) nor the investment bank or lender (no further association with that bond) can be claimed against. Thus, MBSs receive a larger spread and return than a Government bond despite often the same credit rating.

Throughout the process a percentage profit margin is claimed at each step (by the investment bank for example). In effect, the initial interest (mortgage payments) made by the homeowner conclude as the coupon which is received by the institutional investors (although of course the coupon is depleted from the initial interest payments due to the cuts being taken by intermediaries).

3.3 European securitisation and structuring process

Once the investment banks have bought the pool of mortgages from the lenders, they securitise them in a manner that is attractive to the current market. They wish to be able to guarantee sale of these bonds and thus, in accordance with their analysts, evaluate the exact requirements for MBS in the market.

This is done in the form of creating “tranches” or “slices” within the pool. They will ‘slice’ up the pool into different tranches, each of which will have a different issuance amount and credit rating, and each will be given a Class (for example, Class A1 with credit rating AAA, Class A2 credit rating AA, etc). The tranches' issuance amounts will total the amount of the pool itself and, below the lowliest rated tranche (i.e. the bottom class) the investment bank will place a Reserve Fund.

This is a form of protection in ref the event of default. In the case of defaults the reserve fund (usually around 3% of the total deal's value) will be lost first so that investors in the bottom class do not immediately receive a loss. This is beneficial, not only for the bottom class in the deal, but for each tranche, as it gives the whole deal a 3% bumper of protection. The details of this can always be located in the deal's prospectus which can be located on Bloomberg.

3.4 American securitisation model

Figure 10: US securitisation model

The US Model follows the same principles as the European, except an SPV is not used and, instead of the investment banks, the main issuing body is the GSE (Government Sponsored Enterprise). This is often known as ‘pass-through’. The investment banks will still issue MBSs, although these tend to be low credit quality and sub-prime MBSs and CMOs.

In the US model the lenders themselves decide which mortgages to sell off to the GSEs (Agencies ‘Fannie Mae’, ‘Freddie Mac’ and ‘Ginnie Mae’) and which to pass to the investment banks, whilst also usually keeping a select number of mortgages on their own books, in order to show potential investors and analysts that they have confidence in the quality of their own mortgages.

The normal pattern is that they will sell the vast majority of their good credit quality mortgages to the agencies who will back those bonds in issuance. They will then keep a few mortgages on their books, also of good credit quality, whilst any average or poor credit quality mortgages will be sold off to the investment banks for them to structure attractively for the market.

From this point the bonds are issued to the market in the same way as described for the European market.

3.5 Types of MBS/ABS and collateral types

Securitisation occurs on a number of products, which have one thing in common: they all have a proven financial stream and thus have a proven set of future cash flows. From these cash flows the process can be made. Thus, the mortgage market is increasingly large, as areas such as student and car loans have begun to be securitised. The following is a set of big-picture collateral types:

• • Residential Mortgages (RMBS)

• • Commercial Mortgages (CMBS)

• • Student Loans (ABS)

• • Car Loans (ABS)

• • Credit Card Loans (ABS)

• • CDOs and CLOs, which are packaged debt (Collateralised debt obligations & collateralised loan obligations)

3.6 Credit risks for investors in MBS and the mortgage market

With corporate bonds the credit risk lies with the issuer's ability to repay. Therefore, the focus is on the strength of the company, how profitable is it and where does it rank against its competitors?

With MBSs the credit risk is the ability of the mortgage owner/homeowner to make their monthly mortgage payments, because these become the MBS investors' coupons on the bonds, and thus their return. If the homeowners are in creditworthy, stable employment, then credit risk would be minimal in comparison with someone of a lower credit standing. If the income earners are less stable, credit risk would be relatively higher, due to the uncertainty of the individual's situation, and thus their low credit rating.

The credit risk of an MBS is completely dependent on whether the mortgage holder pays back late or does not pay at all, which of course is directly linked to rising interest rates, unemployment, recession in the economy, house prices and other similar factors. The pivotal risk that affects investment in MBS is Pre-payment and the rate at which this is assumed to occur along with the current rate. The issue of prepayment will be discussed separately below.

3.7 Pre-payment

The concept of pre-payment is based around the mortgage holder repaying their loan before the maturity of that loan's term. This occurs for a number of reasons and the holder's ability to pre-pay also depends on the terms of the mortgage. For example, in the US the homeowner can always pre-pay at par and always without any fine or penalty, whilst in Europe each product will have different terms and conditions and will usually involve a pre-pay fine unless previously agreed upon. Pre-payments only refer to payments that exceed the scheduled monthly interest payments and the general term for the speed of these prepayments is the Pre-payment rate. Furthermore, any partial pre-payment is referred to as Curtailment.

Pre-payment will always increase as interest rates drop (for fixed rate mortgages) because the mortgage holders do not wish to have a fixed rate of mortgage which is set at a level higher than that of the current interest rate. In this case the mortgage holder will usually pay off the mortgage and change to one of a lower rate (thus pre-paying). This in turn has a direct relationship on the MBS' weighted average life (WAL).

The weighted average life is the average number of years of unpaid principal that remain outstanding on the mortgage (thus how long until the mortgage is paid off). The WAL is a major indicator on an MBS because, unlike corporate bonds, there is no standardised maturity date for an MBS, due to the varying rates of payments and thus varying future cash flows. A key relationship which must be understood is:

The reason for these pre-payments increasing will not only be based on the interest rates. Other factors that often result in pre-payment are:

• • Receipt of large bonus/inheritance

• • Relocation of accommodation

• • Death and divorce

• • Default due to unemployment (thus full pre-payment due to repossession)

• • Pre-payments tend to increase as the bond approaches maturity (short WAL). This is also known as ‘Aging’

• • Seasonality pre-payments increase during the summer as this is a recognised period when relocation occurs regularly.

Pre-payment rates can be of various types and assumptions. When any MBS is issued, it is given a WAL based on a certain pre-payment rate assumption. The most notable types of pre-payment rates are as follows:

• • SMM – Single Monthly Mortality – projects 1 month forward - % of outstanding balance at the beginning of each month that was pre-paid during the month.

• • CPR – Constant Pre-payment Rate – projects 12 months forward based on historical pay downs – annualised SMM

• • PSA – Pre-payment Standard Assumption - The PSA is a percentage expression of the relationship between the actual and expected CPR based on the PSA pre-payment assumption ramp. The ramp assumes mortgages pre-pay slower during their first 30 months of seasoning. 100% PSA indicates a starting rate of .2% CPR increasing .2% per month for the first 30 months. A constant 6% CPR is assumed for the remaining life of the mortgage. To calculate PSA, use the following formula:

  
  * Where m = number of months since origination of the underlying loans

Investors who wish to have the MBS as a steady stream of income will be concerned about a fall in interest rates as this will directly shorten the life (WAL) of the bond, and will reduce the number of coupon payments they are to receive from those cash flows.