Fixed Income
The Valuation of PAC Bonds Without Complex Models
January 1, 1999
Topics - Fixed Income
Advances in the Valuation and Management of Mortgage-Backed Securities
Simply considering static yields on mortgage securities is insufficient to make good investment choices. Alternatives such as option-adjusted spread (OAS) models can be useful, but they are effectively impractical for investors who do not have internally developed OAS models or large staffs to simultaneously evaluate 20 to 25 similar CMO securities that fit desired investment parameters.
Time constraints alone make estimation of the OAS on all these securities difficult given the possibility of the most valuable bonds trading away. Finally, estimation of OAS requires ''reverse engineering" a CMO structure, which can also be time-consuming.
It would be useful to have a valuation tool or model that could identify in a few moments a small subset of potential investments as having the highest relative value. The portfolio manager could then focus attention on and resources (including OAS) on this subset.
Such an analytic tool becomes increasingly difficult to design, the more sensitive a CMO bond is to factors such as prepayments, yield curve reshaping or volatility. A simple model, however, can be extremely useful in identifying value across at least one popular class of CMO securities: the Planned Amortization Class (PAC) bond.
We propose a zero-volatility option-adjusted spread (ZOAS) model that can be computed for any Planned Amortization Class (PAC) bond in a matter of moments on a simple spreadsheet. The approximate ZOAS technique quickly quantifies relative value across similar PAC bonds and shows the trade-off available to investors in deciding on, for example, different prepayment protection bands or dollar prices (e.g., premiums versus discounts).
This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
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This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.
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