an introduction to callable Debt Securities

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1 an introduction to callable Debt Securities

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3 Table of Contents 1 Introduction 2 Characteristics of Callable Debt 5 Fannie Mae Callable Debt Reverse Inquiry Process 7 Yield Calculations for Fannie Mae Callables 12 Analyzing the Components of Callable Debt 18 Why Investors Buy Callable Debt 20 Call Process 24 Conclusion 25 Glossary 29 Figures

4 Introduction Fannie Mae is a leader in the $11.5 trillion U.S. home mortgage market. The company furthers its housing mission by providing liquidity to the secondary mortgage market and promoting homeownership to low- and moderateincome families through portfolio purchases of mortgage loans and its MBS issuance. To fulfill its ongoing funding needs for the mortgage portfolio, Fannie Mae issues debt in domestic and global capital markets. Fannie Mae issues a variety of debt securities with maturities across the yield curve including short-term debt with maturities of one year or less and long-term debt with maturities of over one year. To effectively manage the interest rate and prepayment risks inherent in a mortgage portfolio, Fannie Mae issues noncallable and callable debt securities. Callable debt is one of the most important financial tools Fannie Mae uses to match the duration of its liabilities to that of its mortgage assets when mortgages prepay. By issuing callable debt, the company gains protection against declining interest rates that tend to cause the mortgage assets of the company s portfolio to prepay more quickly. Fannie Mae can then redeem the company s currently callable debt to match the liquidations of the company s mortgage assets, thus keeping the duration of the company s assets and liabilities closely in line. Callable debt securities also offer investors the opportunity to potentially earn enhanced returns in exchange for taking call risk or selling convexity. Fannie Mae takes very seriously its role in being a flexible, responsive and efficient issuer of callable debt securities and providing investors adequate information to facilitate trading and investment of these securities. The company s callable debt securities issued in the cash market have maturities ranging from one year to thirty years and call lockout periods ranging from three months to ten years or longer. Fannie Mae s callable debt is brought to market mainly through a daily reverse inquiry process involving investors, dealers and Fannie Mae. Fannie Mae provides flexibility to investors seeking customized structures on a reverse inquiry basis based on a need for a specific coupon, maturity date, call date or call feature. Therefore, Fannie Mae issues a diverse group of callable securities with a variety of final maturities and call lockout periods resulting in securities with a wide range of duration and convexity profiles. Different types of investors are able to structure callable securities that match their investment criteria and interest rate outlooks. In 2009 and 2010, Fannie Mae issued approximately $191.8 billion and $309.3 billion, respectively, of callable securities. Introduction 1

5 Headline Characteristics Goes Here OF CALLABLE DEBT CALLABLE DEBT Features Fannie Mae issues callable debt instruments with a variety of maturity dates along the yield curve. Three main structural characteristics of Fannie Mae callable debt securities are the maturity date, the lockout period and the call feature. The maturity date of a callable debt instrument is the latest and final possible date at which the security will be retired and principal will be redeemed. Fannie Mae issues callable debt instruments with a variety of maturity dates along the yield curve. The lockout period refers to the amount of time for which a callable security cannot be called and only interest coupon payments are received by the security holder. For example, with a 10-year noncall 3-year ( 10nc3 ) debt security, the security cannot be called for the first three years. The call feature refers to the type of call option embedded in a callable security. Fannie Mae callable debt securities most often incorporate one of the following call features: n Fannie Mae issues continuously callable or American-style callable debt which can be called after an initial lockout period until maturity date. The investor is compensated for this continuous call feature by receiving a higher yield than on comparable maturity noncallable debt in exchange for allowing Fannie Mae the flexibility to call the security at any time after the lockout period, until the final maturity date, with the requisite amount of notice given to the investor. n Fannie Mae issues callable debt with a one-time or European-style call feature. This call option can only be exercised by Fannie Mae on a single day at the end of the lockout period. European-style callable securities provide the investor an opportunity to obtain a greater spread over a typical Fannie Mae noncallable debt security of the same maturity while reducing the cash flow uncertainty of a continuous call structure. The spread of a European-style callable security will, however, be somewhat lower than an American-style callable security that has the same maturity and lockout period. n Fannie Mae issues Bermudan-style callable debt securities which are callable only on a predetermined schedule of dates, usually on the coupon payment dates after the conclusion of the lockout period. Investors benefit from the increased predictability of cash flows. The spread of a Bermudan-style callable will typically be greater than the spread of a European-style callable, but less than that of an American-style callable with the same maturity and initial lockout period. 2 Characteristics of Callable Debt

6 n Fannie Mae issues Canary-style callable debt securities which incorporate the call features of both Bermudan-style callables and European-style callables. Following its lockout period, a Canary-style callable becomes callable for a designated period of time during which Fannie Mae can call it back on a predetermined schedule of dates much like a Bermudan-style callable. However, once this designated call period concludes, the security is no longer callable. The spread of a Canary-style callable will be greater than the spread of a European-style callable, but less than that of a Bermudan-style callable with the same maturity and initial lockout period. C A L L A B L E D E B T S T R U C T U R E S In addition to straightforward, fixed-rate structures, Fannie Mae has the ability to issue callable floating-rate notes, callable step-up notes and callable zero-coupon notes. Callable Floating-Rate Notes Fannie Mae can issue callable floating-rate notes which have a coupon that is typically tied to a major benchmark index. Investors are able to customize a security with features such as size, interest rate benchmark index or maturity. There are several floating rate indices from which an investor can choose, including three-month Treasury Bills, Prime, Daily Fed Funds, one-month LIBOR, three-month LIBOR, Weekly Fed Funds and Weekly Constant Maturity Treasury. Depending upon the chosen index, various index reset and interest rate payment frequencies are available. Callable Step-up and Step-down Notes Fannie Mae has the ability to issue callable step-up and step-down notes which are variations of standard fixed-rate callable debt securities. They are structured with a coupon that increases or decreases to a specified rate on one or more predetermined dates, typically on interest payment dates. Fannie Mae callable step-up and step-down notes generally become eligible for redemption by Fannie Mae at the time of the first step-up or step-down. Characteristics of Callable Debt 3

7 Callable Zero-Coupon Notes Fannie Mae also issues zero-coupon callable debt securities. Zero-coupon notes are debt securities on which no coupon interest is paid to the investor. Rather, the security is purchased at a discounted dollar price and matures at par. If the option on a callable zero-coupon security is exercised, it is redeemed at a higher dollar price than the origi nal issue price. The yield for a callable zero-coupon security is based on the difference between the original discounted price and the principal payment at the call date. 4 Characteristics of Callable Debt

8 FANNIE MAE CALLABLE DEBT REVERSE INQUIRY PROCESS A variety of investors participate in the reverse-inquiry callable debt issuance process, attracted by the ease with which specific structures can be created to suit particular investor needs, market views, and specifications. Investors can structure callable debt securities designed to achieve certain coupon targets or purchase them based on relative value considerations. Frequently, investors have specific maturity date and call date requirements, and sometimes have preferences for specific call features (European-style, American-style, Bermudan-style, or Canary-style). Fannie Mae has the flexibility to structure callable debt to meet investor preferences and works closely with underwriters to price, provide feedback to and execute callable note structures with its dealer underwriters for investors. In addition, the reverse inquiry process enables investors to obtain the structure of their preference in an efficient and timely manner. Fannie Mae is able to issue callables with a wide variety of maturities and call dates because of the wide range of optionality that is acceptable for the company s asset/liability management needs. Since there is often no need to arrange a simultaneous interest rate swap converting the callable issue into a floating rate liability, it is more straightforward for dealers to underwrite Fannie Mae callables than the callables of other issuers. This results in more efficient pricing and quicker execution. Investors who have interest in specific callable structures typically have discussions with dealers as to the coupon targets, maturity, call date, and call feature parameters. Sometimes a reverse inquiry transaction is driven by a single investor, which is directed to Fannie Mae by one or more dealers. Alternatively, sometimes a transaction is structured for a larger size than any single investor s interest. This is because the dealer observes a larger amount of general demand for that structure. Fannie Mae will in turn analyze the terms of the structure and give feedback to the dealer, and if appropriate, provide a price or spread level at which the transaction can be executed. The terms of a proposed structure are evaluated against internal benchmarks to enable Fannie Mae to reach a decision promptly. Fannie Mae attempts to provide the quickest possible feedback and turnaround to dealers in this respect. The reverse inquiry process is kept as flexible as possible so as to enable investors to meet their needs for callable investments in the most fair and transparent manner. Fannie Mae Callable Debt Reverse Inquiry Process 5

9 Fannie Mae may bring together several dealers to form a single, larger co-underwritten callable notes transaction if they have similar interests in a callable structure. Therefore, investors can obtain the benefit of better liquidity and tradeability from the larger issue size and broader dealer sponsorship of the transaction. Larger issues may qualify for inclusion in the broad bond indices, such as the Barclays Capital U.S. Aggregate Bond Index, which has a minimum outstanding size of $250 million for inclusion in the index. For these reasons, the funding group at Fannie Mae strongly encourages this type of coordination among its underwriting dealers. Fannie Mae issued approximately $309.3 billion callable medium-term notes (MTNs) in 2010 via the reverse inquiry process. As mentioned earlier, Fannie Mae is focused on the issuance of callable MTNs that are $250 million or larger issue sizes with multiple dealer underwriters. Therefore, Figure 1 illustrates, of the total $309.3 billion callable MTNs, $69.7 billion were issued with at least two dealer underwriters and in 139 transactions. FANNIE MAE CALLABLE DEBT INCLUDED IN BOND INDICES Fannie Mae callable debt securities are included in most of the major domestic and international bond indices incorporating U.S. dollar high credit quality securities, such as those published by Citigroup, Barclays Capital, Bank of America Merrill Lynch, and others. This is of particular benefit to those investors who determine their allocations to various fixed-income asset classes in their portfolios based on the composition of an index. 6 Fannie Mae Callable Debt Reverse Inquiry Process

10 Yield Calculations FOR FANNIE MAE CALLABLES Y I E L D C A L C U L A T I O N S When calculating the yield or internal rate of return (IRR) of a callable structure, there are three primary methods that an investor may use: yield-to-maturity, yield-to-call, and yield-to-worst. When making purchase decisions based upon yields, it is important to understand which of the three methods has been used in deriving the stated yield and how changes in the yield curve will affect the final yield performance of the security. Yield-to-maturity The yield-to-maturity calculation assumes that the debt security is not called and the investor holds the bond to its final maturity date. The yield is calculated from the cash flow at maturity and the periodic interest payments generated by the bond (reinvested at a rate equal to the bond s yield-to-maturity). When prevailing interest rates are higher than the coupon on the bond, it is assumed that the issuer will not call the bond. Under these circumstances, yields are commonly quoted using the yield-tomaturity method. Yield-to-call The yield-to-call calculation assumes that the bond is called on the next eligible call date. The yield is calculated from the cash flows of the coupon payments plus the cash flow of the redemption proceeds at the time of the call. When prevailing interest rates are lower than the interest rate on the issue, it is assumed that the issuer will call the security. Accordingly, in such circumstances, yields are sometimes quoted on a yieldto-call method. Yield-to-worst A more conservative alternative to the yield-to-call method is the yield-to-worst method. Many bonds are continuously callable after their first call date (American-style call feature). Because of the uncertainty of the call date, the yield-to-worst method was developed. To derive a yield-to-worst, a yield-to-call is calculated for the initial call date and each coupon payment thereafter. Additionally, a yield-to-maturity calculation is also performed. The yield-to-maturity calculation and all of the yield-to-call calculations are then reviewed with the lowest yield from the group designated as the yield-to-worst. Yield Calculations For Fannie Mae Callables 7

11 PRICING FRAMEWORK OPTION-ADJUSTED SPREAD (OAS) ANALYSIS Callable debt is usually priced and evaluated using an OAS framework similar to that used for other option-embedded securities with cash flows that are sensitive to changes in interest rates. Because a callable debt security consists of a bullet component and a call option component, OAS provides investors with a methodology to analyze a callable debt security by factoring out the yield premium associated with the call option. The OAS of a callable debt security is expressed as a spread over a noncallable yield curve such as Fannie Mae s noncallable Benchmark Notes yield curve, the Treasury yield curve, or the interest rate swaps curve. The OAS analysis framework is based on a forward rate curve derived from the noncallable yield curve employed, volatility assumptions, and the current security price. An OAS model generates the average spread over the forward curve under a number of possible future interest rate paths. For many fixed-income investors, OAS is one of the more useful measurements for assessing value in a callable debt security. Investors also compare the OAS of a callable debt security to the option-adjusted or bullet spreads of other fixed-income securities in analyzing investment decisions and relative value. To calculate an OAS that most accurately captures the value of a callable debt security, investors must incorporate their views with respect to future interest rate volatility. Volatility represents the amount of interest rate fluctuation that is expected over a given period of time. The expectation of future rate volatility may be influenced, or determined in part, from historical measures of volatility. A more detailed discussion of the measurement and impact of interest rate volatility as it relates to Fannie Mae callable debt is provided later in this section. Meanwhile, Bloomberg offers an easy and effective method for calculating the OAS of a specific callable debt security. Investors with access to Bloomberg terminals can analyze option-adjusted spreads through the OAS1 screen by entering a yield curve, implied volatility and price, and setting the Calculate box to O for OAS. The price or volatility can be calculated instead of the OAS just as easily by plugging in the remaining two parameters and changing the Calculate box accordingly. Any standard OAS calculator will return a value for implied volatility, price, or the OAS, given the other two parameters and the yield curve as inputs. These values are quickly accessible and easy to interpret, with no assumption on prepayments or other models for cash flows. 8 Yield Calculations For Fannie Mae Callables

12 BLOOMBERG AOAS SCREEN FOR CALLABLE M E D I U M-T E R M N O T E S Securities Industry and Financial Markets Association (SIFMA) guidelines were introduced in late 2003 for pricing and trading European-style callable U.S. agency debt securities. Fannie Mae believes this development further enhances the transparency and liquidity of callable debt securities in both the primary and secondary markets. The SIFMA guidelines incorporate skew into the volatility assumption and recommend the use of the Black Scholes model as the OAS-to-price calculation convention. The volatility skew adjustment corrects the value of those options that are not at-the-money. Bloomberg s AOAS screen incorporates the SIFMA guidelines and enables investors to value Fannie Mae callable debt securities relative to an up-to-theminute Fannie Mae constant maturity yield curve derived from a live noncallable Benchmark Securities yield curve. The guidelines recommend the use of a single credit issuer specific constant maturity curve, and the relevant swaption volatility to price the callable bond on an OAS basis. For example, in analyzing a Fannie Mae callable debt security, Fannie Mae s noncallable Benchmark Securities constant maturity yield curve should be used. The criteria is limited to callable securities that have European-style (one-time) call options, and are callable at par only on the call date. Also, they are only callable on a coupon date. To perform analyses on these securities, investors may change several of the variables while in AOAS, including the Yield Curve, At-the-money Volatility, OAS, Price, and Settlement Date. Only the Skew Adjusted Volatility and the Forward Strike rate may not be over ridden. Additionally, AOAS requires that the investor enter either an OAS or Price to solve for the other, i.e. enter OAS to solve for Price and vice versa. The security s CUSIP may be used to bring the security into AOAS for analysis by typing the Fannie Mae CUSIP number <CORP> AOAS <GO>. Please see Figure 2. Yield Calculations For Fannie Mae Callables 9

13 Details of each variable are provided below: The Constant Maturity Yield Curve: The default constant maturity yield curve in AOAS for Fannie Mae s callable debt is Fannie Mae s noncallable Benchmark Securities constant maturity yield curve. For other agencies European callable notes, the default yield curve is typically their respective bullet yield curve or, alternatively, the swaps curve. The maturities defining the curve include 3-months, 6-months, 1-year, 2-years, 3-years, 4-years, 5-years, 7-years, 10-years, 20-years and 30-years. The entire Benchmark Securities yield curve is fed to Bloomberg s AOAS screen, except for the 20-year maturity yield. In the case of the 20-year maturity yield, Bloomberg will use a straight-line interpolation between 10-year and 30-year bullet Benchmark yields. The yields provided on Bloomberg s AOAS screen are populated by using the average bid-side yields from contributing broker-dealers for Fannie Mae Benchmark Notes. These yields are then designated to corresponding maturity points on Fannie Mae s constant maturity yield curve and are continually updated throughout the business day. Yields may be refreshed within the AOAS screen by selecting the refresh button on the bottom-right of the screen. The underlying securities that make up the constant maturity yield curve may be viewed in Bloomberg by typing AGPX <GO>. The column labeled Adjust shows the constant maturity adjustment spreads. The adjustment spreads are calculated by subtracting the constant maturity yield from the actual yield for the same maturity point. The constant maturity calculation used for AOAS has been recommended by the SIFMA. Investors can also use the AOAS screen to evaluate a security with the swaps curve or the constant maturity Treasury curve by substituting these curves for the Benchmark Securities default yield curve. At-the-money Volatility: Within the AOAS screen, the default volatility will be the mid-market at-the-money volatility for a comparable European-style option as quoted by the inter-dealer brokerage firm Tullett & Prebon. The Tullett & Prebon swaption volatilities are found in Bloomberg by typing TTSV <GO> 1 <GO> 2 <GO>, for United States Dollar Swaption Volatilities or on the Reuter s icap page The Tullett & Prebon swaption volatilities are updated throughout the day and fed directly into Bloomberg. Investors may override the default volatility assumption that appears in AOAS by changing it to any desired value. 10 Yield Calculations For Fannie Mae Callables

14 Skew Adjusted Volatility: The at-the-money volatility input in the AOAS model is adjusted for skew resulting in a Skew Adjusted Volatility that more accurately reflects current market conditions. The at-the-money volatility input in AOAS is adjusted according to a normalized adjustment factor developed by Blyth and Uglum of Morgan Stanley. The Skew Adjusted Volatility figure that is displayed in AOAS cannot be overridden but may be turned off as indicated by Use Skew Adj Vol field. However, the skew variable may be changed manually but is defaulted, per SIFMA guidelines, to Any change in the skew variable (from 1.00) will result in a different calculated skew adjusted volatility. Forward Strike: The Forward Strike rate shown in AOAS is implied from the Benchmark Securities yield curve and is also adjusted up and down by the OAS assumption. The forward yield is implied by the current yield curve for the period beginning on the exercise date and ending on the maturity date of the underlying swap. The Forward Strike rate that is displayed in AOAS is not a variable that can be overridden. Settlement Date: The settlement date for a new issue defaults to the appropriate date at the announcement of each issue. For a new issue, Fannie Mae will input the settlement date. For outstanding issues or reopenings, the default settlement date in Bloomberg will need to be verified by the investor. The SIFMA guidelines recommend that the settlement date is not to be greater than three days. OAS and Price: The OAS of callable debt securities will be priced on an OAS basis relative to the noncallable Benchmark Securities yield curve. An investor can input an OAS at which a specific transaction is being marketed or an OAS at which an investor is interested in buying or selling a callable debt security to get the corresponding dollar price. Conversely, the desired dollar price of a callable debt security may be entered to obtain the corresponding OAS. The assumption for the above calculation is that the volatility being used has been set to a desired value but the default volatility is the European swaption volatility. It is also possible for the user to calculate an implied volatility using the AOAS screen for a given price and OAS level. Yield Calculations For Fannie Mae Callables 11

15 Analyzing the components of callable debt By analyzing its components, investors are able to assess the value of callable debt. To illustrate this point, we use a par-priced, new issue 5 non-call 2-year ( 5nc2 ) Fannie Mae European-style callable debt security, which has a five-year maturity, two-year lockout, after which it is redeemable at par, as the example in the following discussion. Similar explanations and analogies can be made for other callable structures that Fannie Mae issues. An investment in a par-priced 5nc2 callable new issue can be thought of as the purchase of a 5-year bullet with a coupon equal to the callable s coupon ( 5-year bullet component ) and the simultaneous sale of an option to call a 3-year bullet two years from issue date ( call option component ). Note that the option is being sold on a forward bond. The investor has sold Fannie Mae an option to redeem a three-year bond two years from now. The value of the callable is the difference in the value between these two components: Price 5nc2 callable = Price 5-year bullet Price Call option KEY POINTS ON THE YIELD CURVE The value of the 5-year bullet component depends on the Fannie Mae 5-year bullet yield. The call option embedded in a European-style 5nc2 callable depends on the value of a forward asset, e.g., a 3-year bond beginning in 2 years (termed for convenience a 5/2 forward ). The value of the 5/2 forward is in turn derived from the yields of a 5-year bullet and a 2-year bullet. This analysis of the key points on the yield curve can also be used for callable debt with an American-style call feature. The value of the option depends partly on the 5/2 forward, but because it has a continuous call option, other points on the curve must also be analyzed. Thus, the value of the American-style call option would also depend on the 5/3 forward, the 5/4 forward, and all other forward points within the 2- to 5-year call window. 12 Analyzing the Components of Callable Debt

16 DURATION AND CONVEXITY CHARACTERISTICS The effective duration of a callable debt security falls between the effective durations of bullets maturing on the call date and the maturity date of the callable debt security, respectively. As yields decline, the duration of a callable debt security shortens and approaches the duration to call. As yields rise, the duration lengthens and approaches the duration at maturity. Although lower yields result in higher prices for fixed-income securities, with callable debt securities, the percentage price change will be less than for equal duration bullets in a falling interest rate environment due to the increased likelihood of the bond being called. This characteristic of a callable debt security is known as negative convexity. These negative convexity characteristics are also found in most mortgage securities and some types of asset-backed securities that have embedded options. Fannie Mae typically issues callable debt securities with various effective durations and convexities. Fannie Mae also offers a diverse variety of structures in terms of maturities, call lockouts, and resulting durations and convexities to investors. Figure 3 illustrates the convexity and duration profiles for several of Fannie Mae s most commonly issued European-style callable debt structures. Price 100 Price/Yield Relationship for a Callable Debt Security and a Noncallable Debt Security Negative Convexity Segment of a Callable Debt Security Positive Convexity of a Noncallable Debt Security Fannie Mae also offers a diverse variety of structures in terms of maturities, call lockouts, and resulting durations and convexities to investors. Yield Analyzing the Components of Callable Debt 13

17 IMPACT OF NEGATIVE CONVEXITY ON FANNIE MAE CALLABLES Convexity is a feature of fixed-income securities that has a direct impact on a security s performance and is useful for comparing bonds. If two bonds offer the same duration and yield but one exhibits greater convexity, changes in interest rates will affect each bond differently. The price of a bond with negative convexity is less affected by movements in interest rates than a bond that displays positive convexity or does not have option embedded features. Comparing two securities with the same final maturity, a callable security with a shorter lockout period would have greater negative convexity. For example, for a 5 non-call 3-year security, the longest possible maturity is 5 years and the shortest possible maturity is 3 years. As rates increase, the price-yield behavior of the callable security approaches that of a 5-year bullet because the call option s value decreases as the yield moves higher. Conversely, if rates decline, this callable bond would exhibit negative convexity in that the security behaves more like a 3-year bullet rather than a 5-year bullet because the likelihood of the security being called increases. A 5 non-call 1-year security would exhibit negative convexity as well, but this bond would behave more like a 1-year bullet as yields fall. The price sensitivity for a 1-year bullet would be less than the price sensitivity for a 3-year bullet for the same change in yield. Therefore, as the yield falls on the 5 non-call 1-year security, it would exhibit greater negative convexity than would the 5 non-call 3-year security. The length of the lockout period also impacts the performance of callable debt securities. If investors accept shorter lockout periods they typically obtain higher yields because they are exposed to the risk that their securities could be called for a longer period of time. Since the value of a callable debt security is impacted by the value of the call option, the length of the lockout option affects the convexity profile of the security. It is important to point out that negative convexity is a characteristic of callable debt that the investor has the ability to alter by using Fannie Mae s reverse inquiry process. 14 Analyzing the Components of Callable Debt

18 IMPACT OF INTEREST RATE VOLATILITY ON F A N N I E M A E C A L L A B L E S Interest rate volatility is a market variable that has a significant impact on the initial pricing and returns of Fannie Mae callable debt. Expectations of future interest rate volatility, often referred to as implied volatility, result in changes in the valuation of the embedded option. For example, expectations of higher future volatility will imply higher yields for all callable debt. Alternatively, expectations of lower volatility imply the opposite. Many investors base their predictions of future interest rate volatility on their perspective of historical interest rate volatility. In addition, forecasts on the fundamental health of the economy can be of value in developing predictions of future interest rate volatility. A commonly used measure of volatility for Fannie Mae callable debt (particularly European or one-time callables) is the volatility for a corresponding swaption in the over-the-counter derivatives market. Investors often buy a callable security because they believe that actual future realized volatility will be lower than that implied by the price/yield at which they are able to purchase the security. In this way the level of implied volatility at the time of buying a callable security can be a key relative value indicator for an investor. IMPACT OF YIELD CURVE CHANGES AND RESHAPINGS ON FANNIE MAE CALLABLES The initial pricing and future returns of Fannie Mae callable debt are also determined in part by the initial yield curve and changes in the yield curve over time. The returns of callable debt in a variety of hypothetical future curve shift scenarios (e.g., parallel, flattening, and steepening) are described below. The key points on the yield curve that affect callable debt securities are those corresponding to a security s call and maturity dates. For instance, the Fannie Mae 5nc2 callable debt security would be affected most significantly by 5-year and 2-year yields. The investor could obtain from some combination of 5-year and 2-year bullets an average effective duration equal to the option-adjusted duration of the 5nc2 callable debt security. As a result, the investor in a 5nc2 callable debt security can be thought to have synthetic long positions in 2-year and 5-year bullets. This position is often referred to as a synthetic barbell. Analyzing the Components of Callable Debt 15

19 Impact of the shape of the initial yield curve on new issue pricing The nominal spread of a 5nc2 callable debt security over the 5-year U.S. Treasury yield increases and declines for two main reasons. One reason is due to changes in perceived interest rate volatility, as explained above, and the other is the slope of the yield curve between the 2- and 5-year points. The value of the 5nc2 callable debt security is equal to the value of the 5-year bullet minus the value of the call option. A steep yield curve implies that expected future yield levels are higher than current levels. Because a call option is less likely to be exercised in a high interest rate environment, a steeper yield curve between 2 and 5 years makes the call option embedded in a 5nc2 callable debt security less valuable and, therefore, results in a lower nominal spread for the 5nc2 callable debt security. Conversely, a flatter curve results in a more valuable call option and a higher nominal spread for the 5nc2 callable debt security. Accordingly, investors typically demand higher nominal spreads for callables in flat yield curves when the call option is more valuable and lower spreads in steep yield curves when the call option is less valuable. Impact of various changes in yield curve on total returns Interest rates and the yield curve can be expected to change over time through parallel, flattening, and steepening shifts as well as other more complex types of yield curve changes. 16 Analyzing the Components of Callable Debt

20 Impact of yield curve changes on the performance of premium and discount callables A callable debt security s sensitivity to changes in market variables depends on whether the call option is in-the-money, at-the-money, or out-of-the-money. Investors can determine whether a call option is trading at a premium or a discount by comparing the coupon of the callable to the par forward rate implied by Fannie Mae s bullet curve. For example, the coupon of a 5nc1 would be compared to the 1-year into 4-year par forward rate. For a premium callable, which has a coupon that is higher than the implied forward rate, the embedded option is in-the-money. Consequently, the premium callable will most likely trade on a yield-to-call basis due to the likelihood that it will be called. For a discount callable, which trades below par, the embedded call option is out-of-the-money and will generally trade like a bullet to maturity. The more a premium callable moves into the money, the more it trades like a bullet with a maturity comparable to its lockout period. Conversely, the more a discount callable moves out-of-the-money, the more it trades like a bullet with a maturity equal to its final maturity. These characteristics of premium and discount callables make their prices less sensitive to changes in market variables. At-the-money callables, which trade at or near par, exhibit the most sensitivity to changes in interest rates and volatility because there is more uncertainty associated with the embedded call option. Analyzing the Components of Callable Debt 17

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