SPV July 2011 - Modelling of High-coupon Bonds

The theme investigates fair value pricing for high coupon bonds (8% - 12%). The analysis is commenced using two index based models within the DMBS calculation framework; continuing the work from the theme in SPV 09Q2. The DMBS model is found to be overly sensitive to highly burned out bonds which is true for almost all of the bonds in this segment, leaving almost identical bonds with quite different fair values. In an effort to handle this issue the analysis is extended by simplifying the model and introducing two constant prepayment models based on the implied prepayment rate and another OA Spread index respectively. In order to achieve stability in fair values across time and to obtain a model that fits observed quotes, experiments with subdivisions of coupon rate segments to improve behavior are conducted. This results in another problem as most of the high coupon bonds are not only illiquid; they also seem to jump between bid and ask quotes. As a consequence, carefulness is needed when creating subdivisions of the bonds used for averaging. The conclusion is that it is not unambiguous which model has the best performance. However, the new models seem to produce more stable results, and the results are more comparable for bonds with similar characteristics.