Using the cash flow yield methodology, a spread is calculated over a comparable Treasury security. How is a comparable Treasury determined?

Question

What will be an ideal response?

Answer 1

Comparable treasury issue refers toa Treasury security that is selected (by an independent investment banker) to have an actual or interpolated maturity comparable to the remaining term of the debt securities to be redeemed that would be utilized, at the time of selection and in accordance with customary financial practice, in pricing new issues of corporate debt securities of comparable maturity to the remaining term of such debt securities.

At the time of purchase it is not possible to determine an exact yield for an RMBS; the yield will depend on the actual prepayment experience of the mortgages in the pool. Nevertheless, the convention in all fixed-income markets is to measure the yield on a non-Treasury security to that of a "comparable" Treasury security. One way of determining a comparable Treasury is by matching maturity. However, the repayment of principal over time makes it inappropriate to compare the yield of non-Treasury instruments (such as a RMBS) to a Treasury of a stated maturity. Instead, market participants have used two measures: Macaulay duration and average life. The practice of spreading the yield to the average life on the interpolated Treasury yield curve is improper for an amortizing bond even in the absence of interest-rate volatility. What should be done is to calculate the static spread. This is the yield spread in a static scenario (no volatility of interest rates) of the bond over the entire theoretical Treasury spot rate curve (and not a single point on the Treasury yield curve).

Of interest, the Federal Financial Institutions Examination Councilhas developed the rate spread calculator that gives the spread between the APR and the comparable treasury security utilizing the "Treasury Securities of Comparable Maturity under Regulation C" table, action taken, lock-in date, APR, term (loan maturity), and lien status. The rate spread is the spread between the APR on a loan and the rate on Treasury securities with comparable maturity periods for loan originations in which the APR exceeds the applicable rate by a percentage specified by the Board. The reporting requirement applies to originations of: home purchase loans, dwelling-secured home improvement loans, and refinancings.