Official Blog – Cleantech, Investments, Bonds

What Is a Paydown?

Bonds: refunding by a company of an outstanding bond issue through a smaller new bond issue, usually to cut interest costs. For instance, a company that issued $100 million of 12% bonds a few years ago will pay down (refund) that debt with a new $80 million issue with an 8% yield. The amount of the net deduction is called the paydown.

Mortgage securities are similar to bonds and are investments in a group of mortgages. The paydown feature is typically seen with mortgage-backed securities.

As an example of mortgage-backed securities issuance, assume that an issuer has collected 1,000 mortgages, each worth $100,000 with a 30-year maturity and a fixed interest rate of 6.50%. This $100 million pool of mortgages can be used to back 10,000 bonds, each worth $10,000 with a 30-year term and a fixed coupon rate of 6.00%. Each bond shares the same coupon rate and other features, and importantly, each has a similar claim on all payments. The MBSs are structured so that interest payments on the mortgages are at least sufficient to cover the interest payments due on the bonds (plus the fees of the intermediaries). Principal payments (either scheduled payments or prepayments) on the mortgages are used to pay down the principal on the bonds.

The MBSs exhibit a variety of structures. The most basic types are pass-through participation certificates, which entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets. More complicated MBSs, known as collaterized mortgage obligations or mortgage derivatives, may be designed to protect investors from or expose investors to various types of risk. An important risk with regard to residential mortgages involves prepayments, typically because homeowners refinance when interest rates fall. Absent protection, such prepayments would return principal to investors precisely when their options for reinvesting those funds may be relatively unattractive.

Government or related agencies often issue mortgage securities and people are reimbursed for their investments as the individuals owning the mortgages pay off their loans. Some of the agencies that issue mortgage securities also must provide monthly reports to security owners, which may include something called a paydown factor. A paydown factor is an accounting of the money received by mortgage holders which lists the principal amounts still owed on loans. Any payments to principal undergo a complex formula, which then demonstrates how much money is still owed. When the market is good and mortgage holders are regularly making their payments, this “factor” should show a decreasing amount of money owed monthly, though issuing new mortgages might change this.

Each month a mortgage holder makes payments, the loan is recalculated. Total amount owed may change, unless the mortgage holder is only making interest payments, and in ideal circumstances, each monthly payment pays down part of the mortgage. Borrowers looking at monthly mortgage statements should see a descending balance. Many financial advisers recommend that the balance will decrease faster if people tighten their belts, when at all possible, and increase paydown amount. Instead of simply sticking to the minimum payment, making greater payments to the principal of the loan can be of considerable use in ending a payment obligation sooner. People will also pay less interest overall.

This could be especially important if the loan is upside down, which means the loan amount is higher than the assessed level of the house. Budgeting a larger paydown each month could eventually mean holding equity in the home, instead of simply holding a loan that would not be repaid with the home’s sale.

Bond conversion is the process of swapping of a convertible bond for another asset, generally shares of common stock. While conversion is typically at the option of the investor, in some cases it may be at the option of the issuing company (e.g., forced conversion).

An example of an asset that can undergo conversion is a convertible bond. This type of bond gives the bondholder the option to exchange the bond for a predetermined amount of the bond issuer’s equity. Typically, the bondholder will exercise the option when the total value of the shares received from conversion exceeds the bond’s worth. When convertible bonds are submitted for conversion, the first task is to update any accounts relating to bond premium or discount, accrued interest, and foreign exchange gains and losses on foreign currency denominated debt.

For example, John owns a convertible bond worth $1,000 from XYZ Corp. If the bond can be converted into 100 shares of XYZ, John will most likely exercise the conversion option only when XYZ’s share price exceeds $10.

The conversion may be accounted for under the book value method or market value method.

Book Value Method:

Manner of accounting for a bond conversion into stock. The entry is to debit bonds payable and premium on bonds payable (or credit discount on bonds payable) and credit common stock and premium on common stock. The total credit is based on the bond’s book value. No gain or loss is recognized. Other entries may also be involved such as recording the interest payment prior to the bond conversion.

Market Value Method:

1. Method used to account for a bond conversion. The credit to common stock and premium on common stock may be based either on the market value of the bond or the market value of the stock issued. The difference between the book value of the bond and the market value credited to equity represents a gain or loss.
2. Valuation of inventory at its market value whether above or below cost recognizing an unrealized (holding) loss or gain. This method is not acceptable because to show inventory in excess of cost is not conservative.
3. Method to account for trading (shown under current assets) and available-for-sale (shown under noncurrent assets) equity and debt securities at their market value at the end of the reporting period. The difference between the cost and market value of the securities portfolio is presented as an unrealized loss or gain. For trading securities, the unrealized loss or gain is reported in the income statement. For available-for-sale securities, the unrealized loss or gain for the current year is reported under “other comprehensive income” in the income statement and the cumulative amount is reported under stockholders’ equity in the balance sheet classified as “accumulated other comprehensive income.”

An argument in favour of the market value method is that the transaction is not simply a trade – the exchange of debt for equity represents a change of risk for both the issuer and the holder and therefore is a substantive exchange. Substantive exchange (such as barter transactions) are normally accounted for at market values in order to reflect the economic consequences of the exchange.

A put becomes more valuable as the price of the underlying stock depreciates relative to the strike price. For example, if you have one Mar 12 Taser 10 put, you have the right to sell 100 shares of Taser at $10 until March 2012. If shares of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in the market and sell the shares to the option’s writer for $10 each, which means you make $500 (100 x ($10-$5)) on the put option.

Example of a Put Option on a Stock

Buying a Put

A Buyer thinks the price of a stock will decrease. He pays a premium which he will never get back, unless it is sold before it expires. The buyer has the right to sell the stock at the strike price.

Writing a Put

The writer receives a premium from the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer’s profit is the premium.
• ‘Trader A’ (Put Buyer) purchases a put contract to sell 100 shares of XYZ Corp. to ‘Trader B’ (Put Writer) for $50 per share. The current price is $55 per share, and ‘Trader A’ pays a premium of $5 per share. If the price of XYZ stock falls to $40 a share right before expiration, then ‘Trader A’ can exercise the put by buying 100 shares for $4,000 from the stock market, then selling them to ‘Trader B’ for $5,000.
Trader A’s total earnings (S) can be calculated at $500. The sale of the 100 shares of stock at a strike price of $50 to ‘Trader B’ = $5,000 (P). The purchase of 100 shares of stock at $40 = $4,000 (Q). The put option premium paid to trader B for buying the contract of 100 shares at $5 per share, excluding commissions = $500 (R). Thus S = P – (Q+R) = $5,000 – ($4,000+$500) = $500.

• If, however, the share price never drops below the strike price (in this case, $50), then ‘Trader A’ would not exercise the option (because selling a stock to ‘Trader B’ at $50 would cost ‘Trader A’ more than that to buy it). Trader A’s option would be worthless and he would have lost the whole investment, the fee (premium) for the option contract, $500 (5 per share, 100 shares per contract). Trader A’s total loss are limited to the cost of the put premium plus the sales commission to buy it.

A put option is said to have intrinsic value when the underlying instrument has a spot price (S) below the option’s strike price (K). Upon exercise, a put option is valued at K-S if it is ” in-the-money”, otherwise its value is zero. Prior to exercise, an option has time value apart from its intrinsic value. The following factors reduce the time value of a put option: shortening of the time to expire, decrease in the volatility of the underlying, and increase of interest rates. Option pricing is a central problem of financial mathematics.

Value of a Put

This examples lead to the following formal reasoning. Fix ⱷ an underlying financial instrument. Let Π be a put option for this instrument, purchased at time 0, expiring at time T Ɛ R+, with exercise (strike) price K Ɛ R; and let S: [0, T] → R be the price of the underlying instrument.

Assume the owner of the option Π, wants to make no loss, and does not want to actually possess the underlying instrument ⱷ. Then either (i) the person will purchase ⱷ at expiry, and then immediately exercise the selling option; or (ii) the person will not exercise the option (which subsequently becomes worthless). In (i), the pay-off would be − ST + K; in (ii) the pay-off would be 0. So if K -ST ≥ 0 (i) or (ii) occurs; if K − ST < 0 then (ii) occurs.

Hence the pay-off, i.e. the value of the put option at expiry, is

max{K – ST,0}

which is alternatively written (K – ST) V 0 or (K − ST) + .