Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

TWO-TIERED INDEX BONDS (TTIBS)

A two-tiered index bond or TTIB is a bond, created as part of a floater/ inverse floater combination, which combines elements of both fixed rate tranches and inverse floaters. The bonds are designed to have a fixed coupon rate as long as the reference index is below a certain threshold level. If the index breaches that level, the TTIB’s coupon floats inversely with the index, causing it to drop precipitously from its initial level. This makes an investment in a TTIB similar in concept to being short cap contracts, giving the investor large interest cash flows so long as the index remains below the threshold (or strike) level. The term “two-tiered index bond” derives from the creation of two levels of the index that drive the combination’s coupon rate. The TTIB’s strike rate is the rate where the inverse floater coupon reaches 0%, and the TTIB begins to float inversely to the index. (The strike on a regular inverse is the same as the effective cap of the floater; for a LIBOR floater with an 8.0% cap and a 50 basis point margin, that level is 7.5%.)

In addition to meeting the demand for MBS that have the attributes of a short position in caps, the creation of TTIBs increases the possible leverage on the resulting inverse floater. This results from diverting a fixed portion of the coupon interest available to the inverse to the TTIB, making its coupon more sensitive to changes in the index. The structuring of a hypothetical floater/TTIB/inverse ...