Authored by: Jon Gold
Anyone who has ever paid down a home mortgage, auto loan or other consumer debt is familiar with the concepts of the fixed payment going toward both interest and principal reduction. Early on, it’s nearly all interest service while the principal edges down slowly. Later, as the principal balance declines, the interest nut becomes smaller, so that same payment reduces the principal balance a bit more each go round.
The principal difference: There is an entire class of debt securities where this same principle (if you’ll pardon the pun) applies. A factored security is distinctly different from other debt securities because the principal varies over its life. The percentage of the principal remaining after each wave of debt service payments has been processed is termed the “factor”.
Scheduled principal… There are two types of factored securities. The first type features scheduled and predictable changes to the factor. A common example is a sinking fund provision to a bond, in which the issuer redeems a specific amount of the bond issue on predetermined dates. Absent a default, the schedule can usually be relied upon to determine the amount of principal on any date until maturity. Be aware that some schedules may include an option for the issuer to defer certain redemptions, usually during high interest rate environments, an antiquity which some readers may vaguely recall.
…and unscheduled principal: Far more numerous are those securities whose factor will vary each period, including:
- Mortgage-backed and asset-backed securities (MBS & ABS);
- Collateralized Mortgage Obligations (CMO);
- U.S. Treasury Inflation Protected securities (TIPS);
- Non-United States inflation protected securities also have some form of factor, but we’ll tackle those in a dedicated blog post.
Why is the factor so important? As with your own loan, the principal determines how much interest you pay each period. The smaller the principal, the less you are effectively borrowing at that time and the lower your interest due. Your loan was in all likelihood combined with numerous other similar loans into a tradable security. (See the illustration below for a depiction of this process.) After the periodic payments from each borrower are applied to their individual loan balances, the security’s new factor is calculated based on the residual principal. If exactly 2.75% of the principal has been paid, for example, the factor would then be 0.97250000, since they are published to an 8-digit precision.
Getting what you pay for, or not: Now consider the point of view of the lender, the investor in this security. If it was purchased at a premium, more than $1 was paid for $1 of principal. One would happily do this if the coupon for that security is above market rate. Let’s assume a price of 102, meaning $.02 extra was paid to earn that above market interest rates per $1 loaned. This extra interest income is only paid on whatever principal remains, of course. Have you ever re-financed a loan because rates fell? That causes factors to drop, sometimes precipitously. That $.02 premium evaporates the minute that the dollar of principal is repaid.
Risks and rewards: The art of investing in such securities requires predicting the “speed” of these principal repayments. (Speed actually is the industry term used for this measurement). If done accurately, one may achieve returns superior to securities with similar credit risk that do not expose holders to unexpected principal repayments. For investment purposes, TIPS have a different advantage. Inflation is the enemy of fixed income securities. Just think about the term “fixed income” in the context of rising prices to understand why. TIPS have the same high creditworthiness of other U.S. Treasuries but also provide a level of direct protection against inflation, which most fixed income securities do not.
Mechanically, the factor determines the amount invested in the security each period. They are critical pieces of data for all aspects of factored securities, including modeling, trading, settlement, and compliance.
In Part 2 of this series, we’ll discuss the specific workflows which may differ from those of securities without factors.