Collateralized Mortgage Obligations are a type of Special Purpose Vehicle (SPV), which is separate from the entity that created it.

The CMO is created to issue securities to different investors based on a pool of mortgages owned by the SPV. All the mortgages put together are called a pool. In a CMO the investors buy the bonds issued by the CMO, and receive a periodic payment based on the preset rules.

The CMO structures its mortgage pool in such a way that it can issue bonds with different risk and return profile. So, there will be several classes of bondholders with varying maturities or different date of maturities, known as tranches.

The principal payments from the underlying pool of pass-through securities are used he investors in these bonds will want to protect themselves from the prepayment risk as well as the credit risk. While the prepayment risk cannot be eliminated, it can be distributed among the investors in such a way that one set of investors absorb more risk while the others absorb more risk. This is done through creating different tranches having different risk profiles. The different types of tranches are explained below:

<strong>Sequential Tranches</strong>

In sequential tranching, the principal payments are used to repay the bond holders in each tranche sequentially.
<ul>
	<li>Tranche I, which is also called the short term segment of the issue, is entitled to receive the net interest on the outstanding principal and all the principal payments from the mortgage pool, until it is repaid back to the person who may have initially subscribed to the same.</li>
	<li>Tranche II, which is also called as the intermediate term, is entitled to all the interest on the outstanding principal, and is the next in line after the Tranche I repayment, to get entitled for repayment of the principal payments from the mortgaged pool, until it is repaid back to the subscriber.</li>
	<li>Tranche III, which is also called as the long term tranche, receives monthly net interest and starts receiving all the principal repayments, subsequent to the complete repayment of interest and principal to Tranche I and Tranche II holders.</li>
</ul>
Because the different tranches are expected to mature at different times, they will also offer different yields.

<strong>Parallel Tranches</strong>

In parallel tranching, each tranche is paid on a pro-rata basis. So the bonds in each tranche will have a coupon rate such that the total payment from the mortgage pool is equally divided among the tranches. For example, if the collateral pool pays a coupon on 6%. The the CMO can have two tranches: one is a floater that pays LIBOR with a cap of 10%, while the other is an inverse floater that pays 10% - LIBOR.

<strong>Z-Bonds        </strong>

In this kind of a tranche structure, there is an additional tranche called Z bonds, along with the other tranches. This tranche does not receive any interest payment. The z-bond’s share of payment is instead used to repay the principal of other tranches. The Z-tranche receives the residual payments, that is, the payments are received only after all the other tranches have been fully paid.

These are the important types of tranche structures.

Collateralized Mortgage Obligations and Prepayment Risk

Even though there is no standard classification of bond market, we can broadly classify bonds from the perspective of a country as follows:
<ul>
	<li><b>Internal Bond Market:</b> This is the national bond market of a country. The internal bond market itself has two subcategories:
<ul>
	<li><b>Domestic Bond Market: </b>This refers to the market where the issuers domiciled within the country issue the bonds and where these bonds are traded. For example, in the US, a bond issued by Federal Reserve will be a part of the domestic bond market. A domestic bond is an obligation of a domestic issuer, denominated in domestic currency, and sold and traded in the domestic market.</li>
	<li><b>Foreign Bond Market:</b> This is the market where the issuers from outside the country issue the bonds in the country. For example, Japanese Government issuing a US-dollar denominated bond in the US foreign bond market. Another example is Ford Motor Corporation issuing a yen denominated bond in Japan. Foreign bonds in the US are called Yankee bonds, and foreign bonds in UK are called Bulldog bonds. They are called Samurai bonds in Japanese market, and Panda bonds in China. Note that foreign bonds are similar to domestic bonds except that the issuer is a foreign entity.</li>
	<li><b>Eurobond Market: </b>This is also referred to as the external bond market or the international bond market. This is the market for long-term debt instruments issued and traded in the offshore market. A distinguishing characteristic for Eurobonds is that a Eurobond is offered for sale simultaneously in a number of countries. Eurobonds are bonds issued by a non-resident and denominated in other than the currency of the country in which it is being placed. The bond’s currency of denomination is referred to as an offshore currency. An example is a US-based company issuing a U.S. dollar denominated bond in Europe.</li>
</ul>
</li>
</ul>
Eurobonds are named based on the currency in which they are issues. For example, Eurobonds issued in US dollar are called Eurodollar bonds. Similarly a Eurobond in Japanese yen will be called Euroyen bonds.

Types of Bond Markets

As we have learned earlier, the investors in <a title="Credit Risk in Bonds" href="https://financetrain.com/credit-risk-in-bonds/">bonds are exposed to credit risk</a> as there is a chance that the issuer may default on its obligations. Even though the general perception is that the bonds issued by the government are considered free of default, in reality all bonds expose the investors to credit risk. They are sometimes also referred to as risk-free bonds. The sovereign bonds issued by other country’s governments also have credit risk. To assess the credit risk in these bonds, the rating agencies such as Standards and Poor’s assign sovereign ratings to the bond issues. Sovereign ratings provide an opinion of the level of risk of the investing environment in a country.

There are two types of ratings for sovereign debt:
<ul>
	<li><b>Local currency debt rating:</b> This is the rating assigned to bond issues in local currency. Local currency ratings refer to an entity's ability and willingness to meet all of its financial obligations on a timely basis, regardless of the currency in which those obligations are denominated and absent transfer and convertibility restrictions.</li>
	<li><b>Foreign currency debt rating:</b> This is the rating assigned to bond issues in foreign currency. Foreign currency ratings refer to an entity's ability and willingness to meet its foreign currency denominated financial obligations as they come due.</li>
</ul>
Default rates are traditionally higher for foreign currency debt compared to local currency debt. This is because if the government can raise taxes, it would be able to generate enough local currency to fulfil its local currency debt obligation. The same is not true for foreign currency-denominated debt because the government will have to purchase foreign currency to meet its foreign currency debt obligation. This may lead to depreciation of local currency.

While assigning ratings, the rating agencies consider many factors such as economic risk, political risk, fiscal and monetary flexibility, government’s existing debt burden, external liquidity, and so on.

Credit Risk and Rating of Sovereign Debt

The United State's Treasury issues various types of securities known as US Treasury securities. These securities are backed by full faith and credit of US government, hence, they are perceived to be credit risk-free.
<h2>How are they issued and traded?</h2>
<strong><a title="Four Methods of Distributing Government Securities" href="https://financetrain.com/four-methods-of-distributing-government-securities/">Primary issue method</a>: </strong>Sealed bid auctions on a regular cycle/single-price method. All the winning bidders are awarded securities at highest yield accepted by government (stop-out yield). The auction is generally announced many days before the auction takes place.

<strong>Secondary market:  </strong>Traded over-the-counter through a network of dealers who are always ready to buy and sell with a bid and ask price.

<strong><i>On-the-run Vs. Off-the-run Securities Issue</i></strong>

On-the-run refers to the most recently auctioned issue. The older sets of securities (auctioned earlier) are referred to as off-the run issue.
<h2>Types of Securities</h2>
The US Treasury issues three broad categories of securities, namely, fixed-principal securities, inflation-indexed securities, and treasury STRIPS.

<strong>Fixed-principal Securities</strong>

These can be classified into Treasury bills, Treasury notes, and Treasury bonds.

<i>T-bills</i>
<ul>
	<li>Maturity: Less than 12 months</li>
	<li>Issued at discount to par value, so no coupon payment</li>
</ul>
<i>Treasury notes</i>
<ul>
	<li>Maturity: More than 1 year and less than 10 years</li>
	<li>Issued at approx. par value. Pay coupon.</li>
</ul>
<i>Treasury bonds</i>
<ul>
	<li>Maturity: Greater than 10 years</li>
	<li>Pay coupon</li>
	<li>Treasury doesn’t issue these bonds anymore</li>
</ul>
<strong>Inflation-indexed Treasury Securities</strong>
<ul>
	<li>These are Treasury notes and bonds that provide protection against inflation.</li>
	<li>Commonly known as Treasury Inflation Protected Securities (TIPS).</li>
	<li><strong><i><a href="https://financetrain.com/treasury-inflation-indexed-securities/" target="_blank">Learn more about TIPS</a></i></strong></li>
</ul>
<strong>Treasury STRIPS</strong>

STRIPS is the acronym form Separate Trading of Registered Interest and Principal Securities. These securities are created by the private sector, where the coupon and principal payments from a Treasury note or bond are stripped and sold separately as zero-coupon securities. These are called coupon-only strips and principal-only strips. <strong><i><a href="https://financetrain.com/us-treasury-strips/">Learn more about STRIPS</a></i></strong>.

Overview of U.S. Treasury Securities

In any country, the central government can create an agency or a separate organization that issues bonds for its various departments and different purposes. The bonds so issued are not directly issued by the government, and therefore are called semi-government or agency bonds. Depending on the issue, these bonds may have an implied guarantee of the government.

In the US, such securities are called Federal Agency Securities.

The issues of these agency securities can be broadly classified as: Federally-related institutions, and Government-sponsored enterprises (GSE). Let’s look at these institutions and the kinds of securities issued by them.
<h2>Federally-related Institutions</h2>
These are the arms of federal government.

Examples:
<ul>
	<li>Export-Import Bank of United States</li>
	<li>Tennessee Valley Authority (TVA)</li>
	<li>The Government National Mortgage Association (Ginnie Mae)</li>
	<li>Private Export Funding Corporation</li>
	<li>Maritime Administration</li>
	<li>Small Business Administration</li>
</ul>
These securities are backed by the full faith and credit of the US government (with the exception of the Tennessee Valley Authority and Private Export Funding Corporation).
<h2>Government-sponsored enterprises (GSE)</h2>
These are privately-owned, publicly chartered entities. These enterprises were created to help reduce the borrowing cost of certain sectors such as farmers, homeowners, and students. GSEs issue debentures and discount notes. There are six GSEs.
<ul>
	<li><strong>Federal National Mortgage Association (Fannie Mae):</strong> Credit for residential housing sector.</li>
	<li><strong>Federal Home Loan Mortgage Corporation (Freddie Mac): </strong>Credit for residential housing sector.</li>
	<li><strong>Federal Home Loan Bank:</strong> Credit for residential housing sector.</li>
	<li><strong>Federal Agriculture Mortgage Corporation (Farmer Mac):</strong> Credit for farm proprieties</li>
	<li><strong>Federal Farm Credit System:</strong> Credit for agriculture</li>
	<li><strong>Student Loan Marketing Association (Sallie Mae):</strong> Credit for higher education.</li>
</ul>
<strong>Securities Issued</strong>
<ul>
	<li>Ginnie Mae, Fannie Mae, and Freddie Mac issue <a href="https://financetrain.com/introduction-to-mortgage-backed-securities/">mortgage-backed (pass-through) securities</a>, <a href="https://financetrain.com/collateralized-mortgage-obligations-cmo-and-cmo-tranches/">Collateralized Mortgage Obligations</a>, and stripped mortgage-backed securities.</li>
	<li>Sallie Mae issues <a href="https://financetrain.com/overview-of-asset-backed-securities-abs/">asset-backed securities</a>.</li>
</ul>

Federal Agency Securities

Mortgage-backed securities are one of the many financial innovations born in the US financial markets. The mortgage-backed securities provided a way for investors to get access to a new and untapped source of investment – mortgage loans.

In simple words, a mortgage-backed security (MBS) is a security sold to investors, whose cash flow is backed by a pool of mortgage loans. There are many types of MBS such as pay-through securities, pass-through securities, and collateralized mortgage obligations (CMOs).

In this article, we will look at what mortgage pass-through securities are and how they work.

Let’s first review what a mortgage loan is. A mortgage loan is a loan taken by a homeowner to buy the home or any other property. The loan is secured by the home for which the loan was taken. A mortgage loan will typically have a term within which the loan needs to be repaid, and it will have a monthly payment schedule. The borrower will have to make these monthly payments called Equal Monthly Instalments (EMI) to the lender. EMI consists of the interest payments and a portion of the principal payment calculated in such a way that at the end of the loan term, the entire principal has been paid. This is also called loan amortization. Apart from the interest and principal payment, the borrowers also have the option to make extra payments in order to help them pay off their loan early. These are called prepayment. Prepayments are a common phenomenon. So, a loan typically pays three kinds of cash flows, namely, net interest, scheduled principal payment and prepayment.

Now let’s move our attention to a mortgage pass-through security. In a mortgage-pass through security, thousands of mortgage loans are collected into a pool, known as mortgage pool. With this mortgage pool as a collateral securities are issued to the investors representing a share in the mortgage pool. As the name suggests, the cash flow from the mortgage pool is simply passed on to the investors on a prorate basis.

Since the total cash flow from the collateral pool is uncertain (due to prepayments), the payments to the security holders also are uncertain.

Let’s say the collateral pool contains 1,000 loans each amounting to $100,000. So, the total collateral pool has a value of $100 million. Assume that 100,000 pass-through certificates are issued, each worth $1,000. Each certificate or share represents 0.001% (1/100,000) of the cash flow.

Below are some of the important points about pass-through securities:
<ul>
	<li>The cash flows from the mortgage pool are passed-through to the investors on a pro-rata basis.</li>
	<li>The investors in pass-through MBS are exposed to <a title="Cash Flows and Prepayment Risk" href="https://financetrain.com/cash-flows-and-prepayment-risk/">prepayment risk</a>.</li>
	<li>These securities are issued by government agencies such as Ginnie Mae, Fannie Mae, and Freddie Mac.</li>
	<li>Securities issued by these agencies are also called agency MBS, and are guaranteed for timely payment of principal and interest.</li>
	<li>The loans, to be included in the collateral pool, must satisfy certain criteria, and are called conforming loans.</li>
	<li>Loans not satisfying the criteria become nonconforming loans, and are used in collateral pools for MBS not issued by the agencies.</li>
	<li>The lender creating the loan is called the originator. The originator will generally sell the loan pool to a special purpose vehicle (SPV) who will then create and issue securities to investors.</li>
</ul>

Mortgage Pass-through Securities

Collateralized mortgage obligations (CMOs) are a type of mortgage-backed security that is created with the prime motive of redistributing the prepayment risk to different classes of bondholders.

Let’s take a detailed look at how this works. As we learned before, in a <a title="Mortgage Pass-through Securities" href="https://financetrain.com/mortgage-pass-through-securities/">pass-through security</a>, the monthly cash flow (scheduled interest, scheduled principal, and unscheduled prepayments) are passed on to all the bond holders on a pro-rata basis. So, all the bond holders are equally exposed to the prepayment risk of the entire pool of mortgage loans.

Collateralized Mortgage Obligations eliminate this problem by creating different sets of securities with different priorities such that some securities face less prepayment risk while others face more prepayment risk. In simple words, the streams of principal and interest payments from mortgages are distributed to different classes of Collateralized Mortgage Obligations, known as tranches. Each tranche will suit the objectives and needs of a different set of investors and will carry different principal balances, coupon rates, prepayment risk and maturities.
<h2>Example</h2>
Let’s say the collateral pool contains 1,000 loans each amounting to $100,000. So, the total collateral pool has a value of $100 million. This pool can be used to create three tranches of securities with different characteristics as follows:
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td valign="top" width="159"><strong>Tranche </strong></td>
<td valign="top" width="154"><strong>Par Value</strong></td>
<td valign="top" width="160"><strong>Interest Payment</strong></td>
<td valign="top" width="143"><strong>Principal Payment</strong></td>
</tr>
<tr>
<td valign="top" width="159">Tranche A</td>
<td valign="top" width="154">$50 million</td>
<td valign="top" width="160">Pay monthly based on outstanding principal balance.</td>
<td valign="top" width="143">First to receive all principal payments (scheduled and unscheduled) till all principal is paid-off</td>
</tr>
<tr>
<td valign="top" width="159">Tranche B</td>
<td valign="top" width="154">$30 million</td>
<td valign="top" width="160">Pay monthly based on outstanding principal balance.</td>
<td valign="top" width="143">Receives all principal payments after Tranche A has been paid off fully.</td>
</tr>
<tr>
<td valign="top" width="159">Tranche C</td>
<td valign="top" width="154">$20 million</td>
<td valign="top" width="160">Pay monthly based on outstanding principal balance.</td>
<td valign="top" width="143">Receives all principal payments after Tranche B has been paid off fully.</td>
</tr>
</tbody>
</table>
<h2>Characteristics</h2>
The above table described the broad structure of how tranches work in Collateralized Mortgage Obligations. Let’s look at some of its characteristics:
<ol>
	<li>All tranches receive interest payments based on the outstanding balances.</li>
	<li>Tranche A receives all the principal payments till completely paid off. This tranche first absorbs all the prepayment risk thereby protecting other tranches from any prepayments. The total prepayment risk however, remains the same.</li>
	<li>All the securities within a tranche will have the same characteristics and risks.</li>
	<li>Tranche A will also have shortest maturity followed by Tranche B and then Tranche C.</li>
	<li>The final maturity of each tranche is more certain compared to pass-through securities.</li>
	<li>Each tranche uniquely satisfies the portfolio needs of different investors.</li>
	<li>CMOs are highly sensitive to interest rate changes.</li>
	<li>CMOs can have pools of pass-through securities as collateral.</li>
	<li>There are more complex types of CMO tranches such as Planned Amortization Class (PAC) tranche.</li>
</ol>

Collateralized Mortgage Obligations (CMOs)

We learned about the <a title="Overview of U.S. Treasury Securities" href="https://financetrain.com/overview-of-u-s-treasury-securities/">securities issued by the central government of a country (such as US Treasury)</a>. Along with that the local and state governments also issue bonds, known as municipal bonds (or municipal securities).
<h2>Characteristics</h2>
<ul>
	<li>In the U.S., there is a large market for municipal bonds.</li>
	<li>Though there are both tax-exempt and taxable municipal bonds, most bonds are tax-exempt. Here, tax exemption is for the interest earned from the bond, nor for the capital gains.</li>
	<li>Just like other bonds, investors in municipal bonds also face credit risk and liquidity risk.</li>
	<li>The bonds are traded over-the-counter in dealers market.</li>
</ul>
<h2>Types of Municipal Bonds</h2>
Municipal bonds can be broadly classified into three types, namely, tax-backed debt, revenue bonds, and special bonds. Let’s look at each of them.
<h3>Tax-backed Debt</h3>
<ul>
	<li>These are debt obligations issued by states, counties, districts, schools, etc. and are backed by tax revenue. There are many types of tax-backed debt such as General Obligation Debt, Appropriation-backed Debt, Obligation supported by credit enhancement programs.</li>
	<li><strong>General Obligation Debt:</strong> This could be limited or unlimited obligation debt, as the issuer may have unlimited taxation power. The tax source could be income tax, corporate tax, sales tax, or property tax. In limited tax debt, the issuer is limited by how much tax it can levy to service the debt. Some bonds may be secured by tax revenue plus certain fees and grants (Double-barrelled in security)</li>
	<li><strong>Appropriation-backed Obligation: </strong>These bonds are also called moral obligation bonds and are issued by some states. The key feature is that is these bonds default the state’s legislature can make an appropriation of funds from the state's pledged general tax revenue. It is, however, legally not obligated to do so as in the case of general obligation debt.</li>
	<li> Debt obligation supported by public credit enhancement programs</li>
</ul>
<h3>Revenue Bonds</h3>
<ul>
	<li>Revenue bonds are issued to finance projects or enterprises.</li>
	<li>The revenue from the project or the enterprise being financed is pledged to service the debt.</li>
	<li>The details and rules for revenue disbursement can be different and are set forth in a trust indenture.</li>
</ul>
<h3>Special Bonds</h3>
<ul>
	<li>Special bonds can have features of both tax-backed bonds and revenue bonds.</li>
	<li>Examples are insured bonds and prerefunded bonds.</li>
	<li>The insured bonds, apart from being secured by the issuer’s revenue, are also backed by an insurance policy underwritten by an insurance company. This reduces credit risk for the investors.</li>
	<li>Municipals are sometimes prerefunded and hence the bonds are called prerefunded bonds. This happens when the original bonds are escrowed or collateralized by direct obligations guaranteed by the U.S. government. In case of prerefunded bonds, the bonds are structured such that the refunded bonds are to be called at the first possible call date or a subsequent call date.</li>
</ul>

Overview of Municipal Bonds

Apart from raising capital in the form of equity, corporates also borrow money to run their business. The most common form of borrowing is bank borrowing, which is the first choice for any corporation. Apart from bank borrowing, corporations around the world also have access to corporate debt market where they can raise debt directly from the public by issuing debt securities. In countries such as US, there is a well-developed corporate debt market.
<h2>Types of Corporate Debt Securities</h2>
Corporations can issue four main types of corporate debt securities:

<strong>Corporate Bonds:</strong> Most common type of debt obligation, which may be secured or unsecured.<b></b>

<strong>Medium-term Notes:</strong> Have a unique characteristic that notes are offered continuously to investors by an agent of the issuer. Maturities can vary from under 1 year to 30 years.<b></b>

<b><a href="https://financetrain.com/overview-of-asset-backed-securities-abs/"><strong>Asset-backed Securities</strong></a>: </b>The term<b> </b>Asset-backed securities (ABS) is commonly used to refer to those securities whose underlying assets are not mortgage loans.<b></b>

<b><a href="https://financetrain.com/introduction-to-commercial-paper-cp/"><strong>Commercial Paper:</strong></a> </b>Commercial Paper (CP) is a short-term financial instrument, consisting of unsecured promissory notes issued in bearer form which can be therefore be readily traded. At maturity, the CP issuer pays the amount due to the person presenting the paper.<b></b>
<h2>Rights of Bondholders in case of Bankruptcy</h2>
If corporations are not able to meet their financial obligations, they may file for bankruptcy. In general, the payments to bondholders will have priority over payments to equity holders. Within creditors, some creditors will have priority over others and the rules for this may differ from country to country.

When a corporation files for bankruptcy, it can make a choice to either go for liquidation or opt for reorganization.

In case of liquidation, all the assets of the company are liquidated and the proceeds are distributed to all claimholders (creditors, shareholders, etc.) as per the priority rules. After that the company ceases to exist.

In case of reorganization, the company is closed, and a new reorganized company is created. The bondholders may receive their dues partly in the form of cash and partly in the form of new securities issued by the new reorganized entity.

Under the bankruptcy, Chapter 7 deals with liquidation and Chapter 11 deals with the reorganization of a company.

Bankruptcy proceedings help both the corporate and the bondholders in settling the claims in the most amicable manner possible.

Corporate Debt Securities and Rights of Bondholders

Overview of Bond Sectors and Instruments

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COURSE

Overview of Bond Sectors and Instruments

Lessons

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