Schweser - Study Session 15 - Page 301

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doobsmeister

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On an absolute valuation basis, note that:
1. Tranches trading at a premium (discount) will see gains (losses) when the assumed prepayment rate decreases.
Prepayment rate decreases, bond holder benefits due to captured interest. How would a discounted bon loss from a decrease in prepayment rates when the decrease is seen as a benefit?
 
On a discount bond, your yield-to-maturity above the coupon is essentially driven by the return of principal cash flows. The slower you get that principal cashflow back, the worse off your yield is because of discounting (time value of money).
For example:
I have a 5 year 5% coupon bond I buy at 90% of par at 7.5% yield
If that bond pays back in 4 years instead, my yield-to-maturity is 8%, because the principal cashflows (that i paid 90 cents on the dollar for) are returned to me earlier, so the PV is greater. And the opposite holds if i get re-paid slower.
The interest benefit is offset on a discount bond because the discount rate (7.5%) is higher than the coupon (5%), so that cash flow stream loses money over time.
You can easily try this in Excel with the IRR function.
 
ok, thanks…. Since we are in this topic, I may as well ask:
For a cash flow yield it states “it is the discount rate that makes the price of an ABS or MBS eaual to the present value of its cash flows”
and for the Z spread it states “it is the spread that must be added to each Treasury spot rate to cause the discounted value of an MBS’s cash flows to equal its price”
So what is the difference between a cash flow yield and a z spread then?
 
It’s easiest to see in the extreme: suppose that one month the prepayment is 100%; i.e., the bond is paid off. If it were sold at a premium, there’s a loss; if it were sold at a discount, there’s a gain. In either case, the annual return (gain or loss) is magnified considerably.
Now, at the other extreme, suppose that over the entire life the prepayment is 0%. Then the bondholder gets some interest, and the par value at the end; the annual return is the YTM.
 
Magician, thank you so much.. so just to make sure I get it:
Since I paid for a bond at a premium (say 105) and expect to receive par (100) 10 years from now. Since it was prepaid early (say 2 years from now), the “loss” from the move from 105-100 is magnified since you received par value earlier instead of spreading it for the next 8 years..
Same is true for a discount: if I bought it at say 95, and expect to receive 100 ten years from now, since the prepayment occured, i get the difference early so the returns are much higher.
Is that right?
Thanks again.
 
Exactly.
If you pay a premium, you’re paying for above-market coupons for the remaining life of the bond. If the bond is paid off early, you lose the remaining above-market coupon payments.
If you get a discount, you’re being paid for accepting below-market coupons for the remaining life of the bond. If the bond is paid off early, you retain the payment without having to accept the remaining below-market coupon payments.
 
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