IMP Briefing: Factoring Securities Part II

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By Jon Gold, Director & Senior Consultant

September 26, 2014

In the first IMP Briefing on the topic of securities with factors, we discussed the factor as a principal balance remaining in percentage terms. In Part Two, we’ll look at how specific securities types employ factors.

Two faced: A factored security which pays down its principal balance has both an original and a current face amount. Original face is the nominal trading amount, and absent further purchases or sales of that security, it remains fixed. Current face is the actual (principal) investment amount (i.e. what you own), equal to original face x factor. Therefore, it varies with each pay-down cycle.

Consider an order for $1 million original face. If the factor is 0.95, the current face of that purchase is $950,000.00. If the price of the bond is 102, the settlement amount will be 950,000 x 1.02 = $969,000 plus accrued interest. If the factor has declined to 0.945 the following month and the price has risen to 102-24 (or 1.0275 per $1 of principal), our position market value is now $970,987.50.

Accrued interest is calculated based upon the current face, which is logical since borrowers would only owe interest on the outstanding principal. However, not all trades are executed when up-to-date factors are known. Consider that factors are not available immediately following the borrowers’ payment deadline. A trade is often executed and perhaps even settled during that period in which the new factor is applicable but not yet known. This delay may last weeks or more than a month, depending upon the type of security. (As an aside, this is not “delay days”, which is the number of days until coupon interest paid by borrowers is actually remitted to holders.)

Market practice is to settle trades based upon the latest known factor and to adjust the principal and accrued interest amounts based on the new (applicable) factor when it is published. This is much more straightforward if done prior to the trade having settled.

Consider this sample timeline for a GNMA purchase:

Structured asset backed securities: A simple explanation of a structured security, such as a Collateralized Mortgage Obligation (CMO), might sound like a terribly good oxymoron. For our purposes, however, consider that the reason these securities were invented was the unexpected pay-down risk associated with loans which can be prepaid, such as home loans. These structured securities are all attempting to more closely match risks with buyers’ risk tolerances. A buyer who wants no mortgage principal prepayment risk, for example, can buy a CMO which shifts that risk to other buyers more willing to bear it (for a price, of course). Factors in structured products in general still depict how much principal is remaining. The key difference here is that, rather than a reflection of a large pool of mortgages (or auto loans, or credit card balances, and so on), they instead depict amounts remaining in a particular risk profile, known as a ‘tranche’.

That sinking feeling: Bonds with sinking fund provisions are very similar to the mortgage pass through securities discussed earlier. The primary difference is that the timing and amount of principal pay-downs are known in advance. A sinking fund provision is merely a commitment of the borrower (issuer) to retire a portion of the issue periodically, and the sinking fund factor thus represents the remaining principal. The sinking fund schedule may also be represented as a ‘factor’, or more specifically the date and percentage of the issue to be retired.

Not all sinking fund provisions operate identically. One area of interest would be the price which the borrower will pay to retire debt. Provisions which give the borrower the option to retire part of an issue at the lower of market price or par ($1 on the dollar) will inevitably benefit them at the expense of bond holders, but at least these provisions are codified and known at the time the bond is purchased.

Preferred stock issues may have sinking fund provisions (and hence, principal factors). For example, if a preferred stock issue is redeemable, it will function much like a sinking fund bond.

Don’t let the name fool you. Preferred stock is mechanically closer to debt than to equity, but that is a topic for a future IMP Briefing.

Here’s a TIP: Inflation-linked bonds, both in the U.S. and elsewhere, use a factor to link the security to its inflation index. In the U.S., Treasury TIPS (Treasury Inflation Protected Security) are linked to the Consumer Price Index. Both coupon interest and principal amounts are adjusted for inflation. Each security has an Index Ratio Factor which relates the ‘current’ CPI to that at issuance. (Current CPI is actually a 3 month lagging CPI.) Dividing current into reference provides the index ratio factor, which is then used to determine both inflation-adjusted principal (Face x factor) and semi-annual coupon payment (coupon rate x factor x 0.5).

One other note about U.S. TIPS is that the factor cannot fall below 1.0. This is to protect bondholders’ principal investment in the event of significant deflation. So if the lagged CPI is less than the level at issuance, a factor of 1.0 should instead be used in principal and interest calculations.

Non-U.S. inflation-linked securities function in much the same way. However, beyond using different inflation indices, they may also differ in how (and when) the factor is applied to principal and/or coupon interest, the lag of the indicator used in the ‘current’ factor, or the deflation floor.

Dodging bullets: Factoring securities present managers with a much broader array of cashflow profiles compared to level-paying bullet bonds. Factors are a critical piece of data affecting this wide range of security types. Consider how your organization sources, validates and disseminates them throughout all the systems and processes which rely upon them. Adding a second (check) source is not necessarily outlandish. A factor that looks wrong may be correct, and a factor that looks correct may indeed be wrong. In addition, varying sources may make factors available on different schedules. Contact us here at IMP if you’d like to discuss these or any investment operation challenges you are facing.