Junior Bonds Research Articles

How Informed Were Non-Agency MBS Investors? Evidence from Mortgage Servicing Fees

This paper examines the informativeness of servicing fees regarding the quality of mortgage collateral pools in non-agency securitizations and, ultimately, the value of the mortgage securities. We find that servicing fees capture some unobservable credit risk that explains mortgage default and differentially affects the performance of various security classes. However, junior bond yield spreads at issuance account for this risk, which suggests that investors were more sophisticated than previously thought or that deal issuers were more transparent about collateral credit risk than recognized in the literature. The slow reemergence of non-prime lending as non-qualified mortgage lending makes this study still relevant.

Dynamic risk model for CMO with credit tranching

In this paper, we present a dynamic risk model that can assess the stochastic credit quality of senior tranches of collateralized mortgage obligations (CMO) while supported by any number of junior bond classes. We design the model to be universal and to embed common hazards and retreats within the U.S. housing market. This deployment assists us in resolving real problems when gauging the dynamic creditworthiness of CMOs’ senior bond tranches. Resulting from our subsequent theoretical simulations, we discover the boundaries of these structured financial instruments when exposed to relatively modest probabilities of a broad economic crisis. We demonstrate that despite their diverse supportive structures, CMOs are not as protective as originally thought by many investors when a widespread housing calamity progresses.

Government Bonds Ammunitions for the ECB Quantitative Easing

The aim of this paper is to investigate a range of financial techniques and policy strategies for a Quantitative Easing (QE) program by the European Central Bank (ECB) that would rely on Euro area government bonds purchases under various modalities and guises. In particular, we provide an empirical study of different possible QE arrangements, with a special focus on a proposal of a securitization structure that could clear the different sovereign bonds from credit risk and heterogenerity. The securitization framework proposal is compared with a program of Euro-area public debt direct purchases under two alternative scenarios of: i) pari-passu creditor status of the ECB with respect to private investors; ii) preferred creditor status of the ECB. We consider three cases of “un-managed” (fixed composition) direct purchases according to which member states bonds are purchased in proportion to: i) the “capital key” representing equity holdings of ECB’s shares; ii) a “liquidity-key” representing the relative amount of sovereign bonds outstanding; iii) an equally-weighted portfolio of sovereign bonds. We evaluate the impact of various SPV characteristics - such as bond tranche attachment choice - as well as various financial market scenarios. For these choices we provide a risk management analytical framework based on Monte Carlo simulations. This allows us to compute the probability distribution of credit losses under various credit spreads and default correlation scenarios as well as to design appropriate stress testing procedures to gauge the robustness of our proposed GBB QE solutions. In this version of the paper our modelling strategy relies on the Gaussian copula assumption in default risk correlation. Using end of October 2014 CDS market quotes for 10 Euro-area sovereign bond market, as well as an estimate of a Gaussian copula measure based on historical CDS quotes time series, we conclude that the expected loss would be about 75 basis points on a 5 year horizon for a senior tranche bond with 30% attachment (that is absorbing losses on the government bond portfolio beyond 30% of its value). For all practical purpose, such expected loss and the corresponding credit spread value would be similar to the risk of the German Bund as measured at the same valuation date. As for the junior tranche bond credit risk, we reckon credit spreads between 200 and 300 basis points - depending on the underlying assumptions - which would be comparable with Portuguese government bond credit risk at the same valuation date. Our stress test analysis - based on historical data recorded in November 2011 (Euro area sovereign debt crisis acme) - shows that the securitization structure would effectively limit the credit risk increase on the senior tranche to 5-6% of expected losses estimated in our benchmark case on a 5 year horizon. As one should expect, this fairly solid protection to the senior tranche would come at the cost of a huge credit deterioration for the junior bond tranche to an expected loss level of 60%. This implication should make the junior tranche bond a financial product suitable only for sophisticated institutional investors.

Capital Structure and Debt Priority

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed‐form solutions for the market values of the firm's debt and equity. We find that the magnitude of the spread differential between junior and senior bond yields is positively, but not linearly related to the total debt level and the riskiness of assets. Finally, we provide an in‐depth analysis of probabilities of default and the term structure of credit spreads.

Contingent Claim Conversion under Jump Diffusion

In this paper, we study the design of contingent capital with market trigger under the jump diffusion process. Under the jump diffusion, the issued contingent capital is no longer riskless and has to be priced as a risky junior bond. We find that unique equilibrium requires a very strict condition. Multiple equilibria are expected to be generic. Moreover, even if unique equilibrium condition is satisfied, we show that the conversion ratio is no longer deterministic under the jump diffusion. The conversion ratio becomes a stochastic process related to the jump process of the underlying equity and the conditional expectation of the contingent capital at the conversion time. Thus, making the implementation of contingent capital impossible. The best we can hope to practically implement this conversion design, is to give the minimal conversion ratio (at least the portion required to convert) to conform with Basel III.

Capital Structure and Debt Priority

We study a defaultable firm's debt priority structure in a simple structural model where the firm issues senior and junior bonds and is subject to both liquidity and solvency risks. Assuming that the absolute priority rule prevails and that liquidation is immediate upon default, we determine the firm's interior optimal priority structure along with its optimal capital structure. We also obtain closed-form solutions for the market values of the firm's debt and equity. We next assess the magnitude of the spread differential between junior and senior bond yields, which is positively but not linearly related to the total debt level and the riskiness of assets. We finally provide an in-depth analysis of probabilities of default and the term structure of credit spreads.

Recovery and Returns of Distressed Bonds in Bankruptcy

By linking the trading price of distressed debt after Chapter 11 filing to the ultimate recovery for a large sample of Chapter 11 cases in the past decade, this article finds that senior bonds realize large returns while junior bonds realize losses during bankruptcy reorganization. In addition, this study provides several explanations for the return anomaly observed in the distressed debt market. Liquidation, bankruptcy costs, and active involvement by hedge funds contribute to the understanding of the returns of the distressed bonds. The large negative returns of the junior bonds during bankruptcy reorganization are most likely the result of their initial overvaluation, which was due to their lottery-like features. <b>TOPICS:</b>Fixed-income portfolio management, statistical methods, exchanges/markets/clearinghouses

Default Clustering and Credit Risks in Commercial Mortgage-Backed Securities

This paper proposes an intensity-based pricing model with default dependence structure for CMBS bonds. Three features are incorporated into the proposed model. First, default is a Poisson jump process defined as a function of mortgage rating information in the model. Second, underlying property value risks are modeled using a high dimensional Brownian motion process in order to better capture the driving roles of systematic risk and idiosyncratic risk in determining property value. Third, default dependence structure is built into the extended model. Based on a set of input parameters, we simulate various pricing effects on a hypothetical CMBS using the proposed model structure. The results of the base-line intensity model show that yield spreads on CMBS bonds increase in the recovery rate, but decreases in the hazard rate. Security structured with smaller subordination tranche exposes CMBS bonds to higher default risks. The model also predicts that default clustering increases required yield spreads of CMBS bonds. At a 70% recovery rate and a 3% default hazard rate, yield spreads of Junior bonds are expected to increase by 169 basis points when counterparty risks increase by 50%. The results highlight the importance of clustering risks associated with counterparty default when valuing CMBS bonds.

Default Clustering Risks in Commercial Mortgage-Backed Securities

This paper proposes an intensity-based pricing model with default dependence structure for CMBS bonds. Three features are incorporated into the proposed model. First, default is a Poisson jump process defined by a function of mortgage rating information. Second, property risks are modeled using a high dimensional Brownian motion process that captures both systematic risk and idiosyncratic risk in property value. Third, default dependence structure is built into the extended model. Based on a set of input parameters, we simulate various pricing effects on a hypothetical CMBS using the proposed model structure. The results of the base-line intensity model show that yield spreads on CMBS bonds increase in the recovery rate, but decreases in the hazard rate. Security structured with smaller subordination tranche exposes CMBS bonds to higher default risks. The model predicts that default clustering increases required yield spreads of CMBS bonds. At a 70% recovery rate and a 3% default hazard rate, yield spreads of Junior bonds are expected to increase by 169 basis points when counterparty risks increase by 50%. The results highlight the importance of clustering risks associated with counterparty default when valuing CMBS bonds.

Bond prices in a debt priority structure with absolute priority rule deviation

We study the value of senior and junior bonds with random default and absolute priority rule violation and propose a simple approach to value risky bonds with varying parameters for the violation. Recognizing the sources of violation from equity contribution and value loss from challenges by junior bonds, we specify sharing rules among various claimants to the firm value and obtain the credit spreads of both senior and junior bonds from simulation. We find that the impact of one parameter on credit spreads depends on other parameters and those other parameters have to be considered simultaneously to price corporate bonds.

The impact of junior debt issuance on senior unsecured debt’s risk premiums

Numerous studies have examined the impact of security issuance upon the value of pre-existing debt and equity but the focus has largely been on changes in equity value. We examine changes in senior unsecured debt risk premiums that accompany new junior debt issues. Additionally, we test several hypotheses regarding the potential impacts of junior debt issues. Extant theory suggests senior debt value may be threatened under certain conditions by the issuance of junior debt. Our results indicate that when junior debt replaces bank debt, senior default risk premiums experience abnormal declines. The result is broadly consistent with the elevation of the senior unsecured debt by way of the elimination of a separate and more senior class of debt claimants. In contrast, we also find that larger junior bond issues are associated with abnormal increases in senior risk premiums, broadly consistent with issue size being correlated with negative information about firm cash flows. We find strong evidence of interaction effects. For example, replacement of bank debt results in greater changes in default risk premiums the larger the issue size. We also find lower credit ratings magnify other effects. For example, if the junior debt issued matures before the outstanding senior unsecured bond, senior risk premiums experience abnormal increases for lower rated debt.

Governance and optimal financing for asset‐backed securitization

Asset‐backed securitization (ABS) is an interesting financial innovation whereby debt instruments backed by cash flows generated from income‐producing assets are issued for investment purposes in the capital markets. This study examines the characteristics of ABS transactions in Singapore and evaluates whether proper governance mechanisms have been developed to protect ABS investors. We examined the unique features of the Visor case, such as rental guarantee, large block ownerships of junior bonds, credit enhancement, embedded options, managerial relationships between the SPV and servicers, and critically evaluated the effects of these characteristics on the governance of ABS. Rules on separation of banks' participation in ABS and the accountant's requirement of “clean sale” that affect the ABS structure were also discussed. We also develop a simple information asymmetric model to evaluate the pecking order choice of two different financing methods: collateralized loans and ABS.