By Robert I. Gerber

There are two risks in bond investing that are fairly well understood--the risk of default and the risk of losses due to rising interest rates. But there's a third hazard, less in the public eye until recently but more insidious, and it's the risk of uncomprehended complexity. The consequence can be unexpected volatility--even sophisticated investors aren't immune as was demonstrated by some recent losses in both the public and private sectors that received much media attention. The securities involved are generally classified as derivatives.

As a result, many investors large and small are completely avoiding anything smacking of the "D-word." The dilemma is that derivatives--perhaps a synthetic bond with provisions outside the simple promise to pay fixed interest for a fixed period--can be as helpful as they can be dangerous. Some are actually safer than the bonds they're made from. For these reasons, it's now required of the serious bond investor to know how to gauge the suitability of any derivative for addition to his or her portfolio: to be capable of analyzing whether its advantages outweigh its risk or the other way around.

Pieces of Mortgage Bonds

A good way to illustrate the process is in the context of mortgage derivatives--securities created by dividing mortgage-backed bonds into pieces with different risk characteristics. Most mortgage bonds are vulnerable not only to interest-rate increases but to homeowner behavior as well. When interest rates are rising, mortgage bonds fall in price just like most other bonds. But when interest rates fall, and a rise in price is in the cards, many homeowners refinance their mortgages, with the prepayments used to retire some of the principal of the mortgage bonds, which are essentially bundles of individual mortgage loans. Thus, mortgage bonds become shorter term when interest rates are falling--so their prices don't rise much. In sum, mortgage bonds move more on the downside than the upside.

It was precisely redistributing risks like these that fueled the explosive growth of mortgage derivatives. The most common types are PACs ("planned-amortization-class" securities) and companions (see Exhibit 1). The PAC receives a more predictable amount of interest and principal than either the underlying mortgage bond itself or--particularly--the companions, which absorb most of the uncertainty. If interest rates fall and homeowners start refinancing, the companions receive the early principal payments to protect the PAC. If interest rates rise and refinancing slows, the companions take in less principal so that the PAC can keep receiving it. In other words, the prepayment risk and its unfavorable price behavior are concentrated in the companions.

A PAC can be structured to contain not only less prepayment risk than a regular mortgage bond, but less interest-rate risk as well: to neither rise nor fall as much in price as the regular mortgage bond. So in both dimensions, this derivative is typically less risky than the bond it's based on and much less risky than companions. PACs can actually be used to increase bond portfolio's stability--one of the key qualities that people seek in bonds.

Companions Can Play a Role

Companions, on the other hand, have striking deficiencies. They attempt to compensate through very enticing yields, but these can be a siren song. As shown in Exhibit 2, you get to enjoy companions' high yields if interest rates hold relatively stable; but they tend to lose more than Treasury bonds when interest rates rise and also generally underperform--sometimes massively--when rates fall.

Is there ever a role for a security this risky? To answer that, we make a couple of assumptions:\

• Different sectors of the bond market will be more or less attractive at different times. As opportunities arise, investors should take advantage of them--selectively. It's ill-advised for a portfolio ever to vary too much from the bond market's composition, since market returns support investors' expectations that bonds will be steadier than stocks.
• Key in deciding to make any purchase--derivative or otherwise--is how much it will veer a portfolio's return away from that of the market. Even when attractively priced, too much of a given security can add excessive risk. In this regard, it's critical to look past the risk of the security itself to understand how it will interact with the rest of the portfolio: what it does to overall portfolio risk.

So what would replacing regular mortgage bonds with companions do to a bond portfolio? Our analysis suggests that for a typical intermediate-maturity construction, a 1% position in companions wouldn't much change its overall risk. Even a 10% weighting wouldn't add much risk, in our judgment. But a 20% position would; only extremely high momentary yield--the kind not often seen even in companions--would justify so large a position.

But some derivatives are even riskier--"IOs," for example, which are mortgage bonds that receive interest payments only, not return of principal. While their high yields may appear attractive, their extreme sensitivity to prepayments constrains their roles. A 1% position may be appropriate, but their risk accelerates rapidly; just a 5% weighting exposes traditional bond investors to levels of risk that they'd find unacceptable.

In sum, derivatives themselves are neither good nor bad; whether they are used prudently or recklessly in your clients' bond portfolios is a function of how well they are understood. This is one of the arenas in which an active bond manager can add value.

Robert I. Gerber, Ph.D., is the senior portfolio manager responsible for mortgage-bond analysis and investments at Sanford C. Bernstein & Co., Inc.

WHEN A HOME EQUITY LINE OF CREDIT IS RIGHT FOR YOU

By Charles Hamm, President and CEO, Independence Savings Bank

Here are some frequently asked questions with answers to help better understand when home equity lines of credit may be a useful means of financing.

What should I look for when shopping for an equity line?

Look for a lender that offers a credit line that best suits your needs by reviewing the terms and conditions of their credit agreement. This should include the costs associated with the credit line such application fees, closing costs, and the annual percentage rate (APR). Because an equity line usually has a variable interest rate, it is important to know how the rate is arrived at, how frequently it adjusts, and the maximum interest rate that may be charged during the life of the account.

How is the amount of my credit line determined?

You are approved for a specific credit limit which is the most you may borrow at any one time. The credit limit amount is usually determined as a percentage of the home's appraised value less any balance on your mortgage. For example, if we assume a lender will lend up to 75% of the equity, and your home is appraised at $100,000 and there is a mortgage balance of $40,000, then the maximum credit line that you may qualify for this is $35,000 ($100,000 x 75%­$40,000 = $35,000). However, in determining the actual credit line approved, your lender will also consider your ability to repay based upon income and outstanding debts as well as your credit history.

How do I access my equity line?

Once your credit line is approved, you may borrow up to your maximum credit limit. This is typically done by using special checks that are given to you for your maximum credit limit and home equity account. However, some lenders may also permit access to the home equity line of credit by use of a credit card. Some accounts may require a minimum dollar amount for each advance of credit.

When and how do I repay the amount borrowed?

There is usually a set time period that the credit line is available to you. Typically this is for five to 10 years during which you pay the interest on any outstanding balance. Although not required, you may repay principal as well. At the end of this "interest only" period, the lender may offer you an option to renew the credit line for an additional period of time. If not, the credit line is no longer available to you and repayment of the principal amount borrowed plus interest begins. This may often be for a period of 10, 15, or 20 years.

What if I need a set amount and not a credit line?

Some lenders also offer a closed-end home equity loan. This loan provides you with a fixed amount to borrow and you begin to repay the principal and interest over a fixed term. Typically this type of equity loan is offered for smaller loan amounts that may range for $5,000 to $50,000, although some lenders may offer higher amounts.

And remember, because your home is used as collateral you have the right to cancel a home equity loan or line of credit within three days from the
day the account is opened, regardless which financial institution you choose. Simply inform the creditor in writing within the three-day recision period and they will cancel the security interest
on your home.

Editor:
Milton Miller, CPA
Consultant

Contributing Editors:
Andrew Blackman, CFP, CPA\PFS
Shapiro & Lobel LLP