Securitized and Municipal Bonds

Securitized and municipal bonds Securitized bonds (Securitized Bonds) and municipal bonds (Municipal Bonds, Munis) represent specialized segments of the fixed income market, each possessing unique risk and return characteristics that go beyond traditional corporate and government bonds. For a manager of a large portfolio, these instruments provide additional diversification (Diversification), unique tax advantages (Tax Advantages), and access to risk premia (Risk Premia) unavailable in other bond market segments. The combined size of the securitized and municipal markets in the U.S. exceeds $15 trillion, creating a deep and liquid investment universe for institutional investors.

MBS and ABS: Structure and Risks
Mortgage-backed securities (Mortgage-Backed Securities, MBS)—bonds backed by a pool of mortgage loans—are the largest segment of the securitized market, with a volume exceeding $9 trillion. Agency MBS—issued or guaranteed by government agencies (Ginnie Mae—full U.S. government guarantee; Fannie Mae and Freddie Mac—implied guarantee)—carry minimal credit risk but are subject to significant prepayment risk (Prepayment Risk). Non-Agency MBS (Private Label MBS)—issued by private companies without a government guarantee—carry both credit risk and prepayment risk.

Structure of MBS: a mortgage pool generates monthly cash flows (Monthly Cash Flows) consisting of interest payments (Interest) and principal amortization (Principal Amortization), which are either passed through to bondholders (Pass-Through Securities) or distributed by tranches (Collateralized Mortgage Obligations, CMO).

Asset-Backed Securities (ABS)—securitized pools of non-mortgage consumer loans:

• Auto Loan ABS—the most liquid and predictable ABS subsector with a volume of $250B+, secured by automobiles (self-amortizing asset), structured into AAA–BB tranches;
• Credit Card ABS—revolving credit lines, structured through a Master Trust;
• Student Loan ABS—including both federal (FFEL) and private loans;
• Equipment ABS—lease payments for industrial, medical, and IT equipment.

Each type of ABS has a specific cash flow and risk profile: auto loans ABS display predictable prepayment rates (10–15% CPR), whereas credit card ABS are characterized by variable payment rate and the possibility of an early amortization event (Early Amortization Event) when portfolio quality deteriorates.

Analysis of Prepayment Risk (Prepayment Risk)
Prepayment risk is a central factor in MBS analysis and significant for some ABS types. The borrower has the right to prepay a mortgage without penalty, creating an embedded call option (Embedded Call Option) for the borrower and negative convexity (Negative Convexity) for the investor. When rates decline, borrowers massively refinance mortgages at lower rates, returning principal to the investor at a time when reinvestment is only possible at lower rates (Reinvestment Risk). When rates rise, prepayments slow (Extension Risk), increasing the effective duration of MBS and amplifying price losses.

Prepayment Models:

• PSA (Public Securities Association)—the standard model, assumes linear growth in conditional prepayment rate (CPR) from 0% to 6% over the first 30 months, then stable 6% (100% PSA). Actual prepayment rates deviate significantly from PSA depending on:
• the spread between the MBS coupon rate and current market rates (Refinancing Incentive)—the wider the spread, the faster the prepayments;
• seasonality—refinancing activity is higher in spring/summer;
• burnout effect—borrowers who did not refinance in the first wave of falling rates are less likely to refinance subsequently;
• Media Effect—media coverage of low rates stimulates refinancing waves.

Bloomberg BVAL Prepayment Model, Andrew Davidson & Co, Yield Book—leading proprietary models used by institutional investors.

Municipal Bonds and Tax Advantages
Municipal bonds (Municipal Bonds, Munis) are debt securities issued by states, cities, counties, and specialized authorities (Authorities) to finance public infrastructure. Market size: $4 trillion+. Key advantage: interest income from federal municipal bonds is exempt from federal income tax (Federal Income Tax Exemption) and, in many cases, from state and local taxes (Triple Tax-Exempt for residents of the issuing state).

Two main types:

• General Obligation Bonds (GO)—backed by the full faith and credit of the issuer and its tax base;
• Revenue Bonds—backed by revenues from a specific project (toll road, airport, water treatment plant, hospital).

Tax-Equivalent Yield (TEY) is the key metric for comparing municipal bonds with taxable bonds: $TEY = \frac{\text{Muni Yield}}{1 - \text{Marginal Tax Rate}}$
At a top federal tax rate of 37% (maximum for UHNWI), a municipal bond yielding 3.5% is equivalent to a taxable bond yielding 5.56%. Taking into account the Net Investment Income Tax (NIIT) of 3.8%, the effective top rate reaches 40.8%, making TEY even more attractive: $3.5% / (1 - 0.408) = 5.91%$. For an investor with a high tax burden, municipal bonds can provide higher after-tax yields than comparable corporate bonds.

Duration, Convexity, and Yield to Worst
Duration and maturity are interrelated but distinct concepts. Maturity is the calendar date of the bond’s final repayment. Duration is a measure of a bond's price sensitivity to interest rate changes, expressed in years. Macaulay Duration is the weighted average time to receive a bond’s cash flows.
$\text{Modified Duration} = \frac{\text{Macaulay Duration}}{1 + y/k},$
where $y$ is yield, $k$ is coupon frequency.

Rule: for a 1% (100 bps) change in yield, the price of a bond with a Modified Duration of 5 years will change by approximately 5%.

Effective Duration is the measure that properly accounts for embedded options (call provisions in munis, prepayment option in MBS), providing a more accurate assessment of interest rate risk for bonds with optionality.

Convexity is a measure of the nonlinearity of a bond’s price-yield relationship, the second term in the Taylor expansion of the price function.

• Positive convexity: when rates fall, the price rises faster than duration predicts; when rates rise, the price falls more slowly—“asymmetric protection,” beneficial to the investor.
• Negative convexity: characteristic of callable bonds and MBS; when rates fall, price gains are capped by the call price or by prepayment acceleration.

Yield to Worst (YTW)—the minimum yield an investor may receive under any possible call/put scenario—is the most conservative and practically useful yield metric for bonds with embedded options. For municipal bonds with call provision (most munis are callable 10 years after issue), the difference between Yield to Maturity (YTM) and YTW can be 50–100+ bps, making YTW the only correct metric for decision-making.

Practical recommendations for the portfolio manager:

• Use a barbell strategy—combining short-term (1–3 years) and long-term (15–30 years) bonds, skipping the intermediate part of the curve—to optimize the yield-to-interest-rate-risk ratio in anticipation of falling rates;
• For monitoring, use Bloomberg BVAL (Bloomberg Valuation) for daily fair value assessment of illiquid munis and MBS;
• Monitor the Muni/Treasury ratio (municipal bond yield to Treasury yield ratio)—when the ratio > 90%, munis offer exceptional relative value; at a ratio