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Understanding Callable Securities PFM Asset Management

Understanding Callable Securities PFM Asset Management. Nancy Jones and Nsesa Kazadi 50 California Street, Suite 2300 San Francisco, CA 94111 415-982-5544 www.pfm.com. Yield on Bullet Security + Call Option Premium Yield on Callable Security. Callable Federal Agencies.

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Understanding Callable Securities PFM Asset Management

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  1. Understanding Callable SecuritiesPFM Asset Management Nancy Jones and Nsesa Kazadi 50 California Street, Suite 2300 San Francisco, CA 94111 415-982-5544 www.pfm.com

  2. Yield on Bullet Security + Call Option Premium Yield on Callable Security Callable Federal Agencies • Federal Agency security with a call option • Call option allows the issuer to redeem the security prior to maturity, at the call date • One time • Continuously • Periodically • Issuers pay a premium in the form of a higher yield for this feature • The option premium is based on: • Current interest rates • Expected future rates • Call structure

  3. Principal is returned early if security is called $1,026,250 $1,026,250 $26,250 Callable or Non-Callable 2 year, non-call one, 5.25% Coupon $1,000,000 par $26,250 Year 2 Year 1 -$1 million Interest Principal

  4. Pros High credit quality Additional yield advantage Cons Date principal is returned is uncertain More challenging to analyze competitive offers Callable Federal Agency Securities

  5. To Maturity To Next Call Maturity Distribution: Call vs. Maturity Date $140 $120 $100 $80 millions $60 $40 $20 $0 0-1 Year 1-2 Years 2-3 Years 3-4 Years 4-5 Years

  6. Risk of Callable Securities 3-Year U.S. Treasury Note January 1, 2000 – February 17, 2006 8.00% Purchase of 3-year callable, 1-year non-call protection 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- 00 00 01 01 02 02 03 03 04 04 05 05 06 Source: Bloomberg

  7. Current Rates Rates as of February 9, 2006

  8. Select the Best Offer Which security would you buy?

  9. Advantages

  10. Still Undecided? “OAS” it! • Option Adjusted Spread Analysis (OAS) can help you select the cheapest callable security. • OAS models calculate the value of the call option to arrive at an “option-free” yield spread. • The OAS provides an apples-to-apples comparison of callable securities with similar structures. • You can also compare the OAS to yield spreads of similar non-callable securities.

  11. Option Adjusted Analysis FHLMC 5.125% February 27, 2008 O.A.S. Effective Duration

  12. Option Adjusted Analysis FNMA 5.10% February 22, 2008 O.A.S. Effective Duration

  13. More Yield = Better Returns?Not Always • When buying callable securities, more yield does not always equal more income or better returns! • Reinvestment risk: securities get called when rates fall, thus reducing income • Negative convexity: price appreciation is limited while potential price decline is unlimited

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