Margin stepup

[FrmL2_Aspirant]

Hi @David Harper CFA FRM ,
A question came up in Nov'16 Part 2, just wanted your insight, how to interpret it?



What leads to decrease in credit var of junior tranche - either margin step-up for all tranches or increase in notional of senior tranche

thanks a lot for any leads.

Tagging @bpdulog , @Ali Ehsan Abbas for notification

 

[bpdulog]

Hi @David Harper CFA FRM any input into this? Margin step up is listed as a credit enhancement

 

[saurabhpal49]

Hi David,
Could you please explain what is margin stepup with a simple example

Thanks

 

[David Harper CFA FRM]

Hi @saurabhpal49 I assume that Choudhry is referring to a coupon with an increasing step function. If the bond/tranche is based on an index, then the margin would be added to determine the floating coupon rate; e.g., maybe the floating rate for a senior tranche = LIBOR + 50 basis point margin = coupon rate, where 50 basis points is the margin.

Note the text that I located below (from Fabozzi). It sounds to me that Choudrhy is saying: these are callable bonds where the margin increases (steps-up) on the call date so maybe something like, the margin steps up to + 100 basis points in two years, such that, if you are the investor buying these, you have some protection in rising yields where the issuer would not otherwise be incentivized to call the bond (the issuer wants to call the bond if yields go down, so the issuer can refinance at the lower rate). It's a new phrase to me, in truth, but that's what I infer: it sounds like the same "step up" below except we are talking about a floating rate coupon (of an ABS trance) such that the margin is stepping up (increasing) as the component added to the index. I hope that's helpful:

"The lattice-based recursive valuation methodology is robust. To further support this claim, we address the valuation of two more exotic structures—the step-up callable note and the range floater. Valuing a Step-Up Callable Note Step-up callable notes are callable instruments whose coupon rate is increased (i.e., “stepped up”) at designated times. When the coupon rate is increased only once over the security’s life, it is said to be a single step-up callable note. A multiple step-up callable note is a step-up callable note whose coupon is increased more than one time over the life of the security. Valuation using the lattice model is similar to that for valuing a callable bond described earlier except that the cash flows are altered at each node to reflect the coupon characteristics of a step-up note. Suppose that a four-year step-up callable note pays 4.25% for two years and then 7.5% for two more years. Assume that this note is callable at par at the end of year 2 and year 3. We will use the binomial tree given in Exhibit 40–9 to value this note." -- Fabozzi, Frank J.. The Handbook of Fixed Income Securities, Eighth Edition (Kindle Locations 15809-15813). McGraw-Hill Education. Kindle Edition.