callable brochure

8/3/2019 Callable Brochure

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an introduction tocallable debt Securitie


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Table of ConTenTs

1 Introduction

2 CharacteristicsofCallableDebt

5 FannieMaeCallableDebtReverse InquiryProcess

7 Y ie ld Calcu lationsforFannieMaeCallables

12 AnalyzingtheComponentsof Cal lableDebt

18 WhyInvestorsBuyCa llable Debt

20 CallProcess

24 Conclusion

25 Glossary

29 Figures


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InTodCTIon

annie Mae is a leader in the $11.5 trillion U.S. home mortgage market. Te

company furthers its housing mission by providing liquidity to the secondary

mortgage market and promoting homeownership to low- and moderate-

income families through portfolio purchases of mortgage loans and its MBS

issuance. o fulll its ongoing funding needs for the mortgage portfolio, Fannie Mae

issues debt in domestic and global capital markets.

Fannie Mae issues a variety of debt securities with maturities across the yield curve

including short-term debt with maturities of one year or less and long-term debt with

maturities of over one year. o eectively manage the interest rate and prepaymentrisks inherent in a mortgage portfolio, Fannie Mae issues noncallable and callable debt

securities. Callable debt is one of the most important nancial tools Fannie Mae uses to

match the duration of its liabilities to that of its mortgage assets when mortgages

prepay. By issuing callable debt, the company gains protection against declining

interest rates that tend to cause the mortgage assets of the companys portfolio to

prepay more quickly. Fannie Mae can then redeem the companys currently callable

debt to match the liquidations of the companys mortgage assets, thus keeping the

duration of the companys assets and liabilities closely in line.

Callable debt securities also oer investors the opportunity to potentially earn

enhanced returns in exchange for taking call risk or selling convexity. Fannie Mae takesvery seriously its role in being a exible, responsive and ecient issuer of callable debt

securities and providing investors adequate information to facilitate trading and

investment of these securities. Te companys callable debt securities issued in the cash

market have maturities ranging from one year to thirty years and call lockout periods

ranging from three months to ten years or longer. Fannie Maes callable debt is brought

to market mainly through a daily reverse inquiry process involving investors, dealers

and Fannie Mae. Fannie Mae provides exibility to investors seeking customized

structures on a reverse inquiry basis based on a need for a specic coupon, maturity

date, call date or call feature. Terefore, Fannie Mae issues a diverse group of callable

securities with a variety of nal maturities and call lockout periods resulting in securi-

ties with a wide range of duration and convexity proles. Dierent types of investors

are able to structure callable securities that match their investment criteria and interest

rate outlooks.

In 2009 and 2010, Fannie Mae issued approximately $191.8 billion and $309.3

billion, respectively, of callable securities.

F

Introduction 1


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HdIn Gos H

CALLABLEDEBTFEATRE

Tree main structural characteristics of Fannie Mae callable debt securities are the

maturity date, the lockout period and the call feature.

Te maturity date of a callable debt instrument is the latest and nal possible date

at which the security will be retired and principal will be redeemed. Fannie Mae issues

callable debt instruments with a variety of maturity dates along the yield curve.

Te lockout period refers to the amount of time for which a callable security cannot

be called and only interest coupon payments are received by the security holder. For

example, with a 10-year noncall 3-year (10nc3) debt security, the security cannot

be called for the rst three years.

Te call feature refers to the type of call option embedded in a callable security.

Fannie Mae callable debt securities most often incorporate one of the following

call features:

n Fannie Mae issues continuously callable or American-style callable debt which

can be called after an initial lockout period until maturity date. Te investor is

compensated for this continuous call feature by receiving a higher yield than on

comparable maturity noncallable debt in exchange for allowing Fannie Mae the

exibility to call the security at any time after the lockout period, until the nal

maturity date, with the requisite amount of notice given to the investor.

n Fannie Mae issues callable debt with a one-time or European-style call feature. Tis

call option can only be exercised by Fannie Mae on a single day at the end

of the lockout period. European-style callable securities provide the investor

an opportunity to obtain a greater spread over a typical Fannie Mae noncallable

debt security of the same maturity while reducing the cash ow uncertainty of

a continuous call structure. Te spread of a European-style callable security

will, however, be somewhat lower than an American-style callable security that

has the same maturity and lockout period.

n Fannie Mae issues Bermudan-style callable debt securities which are callable only

on a predetermined schedule of dates, usually on the coupon payment dates after

the conclusion of the lockout period. Investors benet from the increased

predictability of cash ows. Te spread of a Bermudan-style callable will typically

be greater than the spread of a European-style callable, but less than that of an

American-style callable with the same maturity and initial lockout period.

Fannie Mae

issues callable

debt instruments

with a variety

o maturity

dates along the

yield curve.

CHCTIsTICs of Cb dbT

2 Character istics ofCa llable Debt


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n Fannie Mae issues Canary-style callable debt securities which incorporate the

call features of both Bermudan-style callables and European-style callables.

Following its lockout period, a Canary-style callable becomes callable for a

designated period of time during which Fannie Mae can call it back on a prede-

termined schedule of dates much like a Bermudan-style callable. However, once

this designated call period concludes, the security is no longer callable. Te spread

of a Canary-style callable will be greater than the spread of a European-style

callable, but less than that of a Bermudan-style callable with the same maturity

and initial lockout period.

CALLABLEDEBTTRCTRE

In addition to straightforward, xed-rate structures, Fannie Mae has the ability to issue

callable oating-rate notes, callable step-up notes and callable zero-coupon notes.

CallableFloating-RateNotes

Fannie Mae can issue callable oating-rate notes which have a coupon that is typically

tied to a major benchmark index. Investors are able to customize a security with features

such as size, interest rate benchmark index or maturity. Tere are several oating rate

indices from which an investor can choose, including three-month reasury Bills,

Prime, Daily Fed Funds, one-month LIBOR, three-month LIBOR, Weekly Fed Funds

and Weekly Constant Maturity reasury. Depending upon the chosen index, various

index reset and interest rate payment frequencies are available.

Callabletep-upandtep-downNotes

Fannie Mae has the ability to issue callable step-up and step-down notes which are

variations of standard xed-rate callable debt securities. Tey are structured with a

coupon that increases or decreases to a specied rate on one or more predetermined

dates, typically on interest payment dates. Fannie Mae callable step-up and step-down

notes generally become eligible for redemption by Fannie Mae at the time of the rst

step-up or step-down.

CharacteristicsofCallableDebt 3


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CallableZero-CouponNotes

Fannie Mae also issues zero-coupon callable debt securities. Zero-coupon notes are debt

securities on which no coupon interest is paid to the investor. Rather, the security is

purchased at a discounted dollar price and matures at par. If the option on a callable

zero-coupon security is exercised, it is redeemed at a higher dollar price than the original

issue price. Te yield for a callable zero-coupon security is based on the dierence

between the original discounted price and the principal payment at the call date.

4 Character istics ofCa llable Debt


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A variety of investors participate in the reverse-inquiry callable debt issuance process,

attracted by the ease with which specic structures can be created to suit particular

investor needs, market views, and specications. Investors can structure callable debt

securities designed to achieve certain coupon targets or purchase them based on relative

value considerations. Frequently, investors have specic maturity date and call date

requirements, and sometimes have preferences for specic call features (European-style,

American-style, Bermudan-style, or Canary-style).

Fannie Mae has the exibility to structure callable debt to meet investor preferences

and works closely with underwriters to price, provide feedback to and execute callablenote structures with its dealer underwriters for investors. In addition, the reverse

inquiry process enables investors to obtain the structure of their preference in an

ecient and timely manner. Fannie Mae is able to issue callables with a wide variety of

maturities and call dates because of the wide range of optionality that is acceptable for

the companys asset/liability management needs. Since there is often no need to arrange

a simultaneous interest rate swap converting the callable issue into a oating rate

liability, it is more straightforward for dealers to underwrite Fannie Mae callables than

the callables of other issuers. Tis results in more ecient pricing and quicker

execution.

Investors who have interest in specic callable structures typically have discussionswith dealers as to the coupon targets, maturity, call date, and call feature parameters.

Sometimes a reverse inquiry transaction is driven by a single investor, which is directed

to Fannie Mae by one or more dealers. Alternatively, sometimes a transaction is

structured for a larger size than any single investors interest. Tis is because the dealer

observes a larger amount of general demand for that structure. Fannie Mae will in turn

analyze the terms of the structure and give feedback to the dealer, and if appropriate,

provide a price or spread level at which the transaction can be executed. Te terms

of a proposed structure are evaluated against internal benchmarks to enable Fannie Mae

to reach a decision promptly. Fannie Mae attempts to provide the quickest possible

feedback and turnaround to dealers in this respect.

Te reverse

inquiry process

is kept as exible

as possible so as

to enable investors

to meet their

needs or callable

investments inthe most air

and transparent

manner.

fnnI M Cb dbT Vs InQIY PoCss

FannieMaeCallableDebtReverseInquiryProcess 5


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Fannie Mae may bring together several dealers to form a single, larger co-underwritten

callable notes transaction if they have similar interests in a callable structure.

Terefore, investors can obtain the benet of better liquidity and tradeability from the

larger issue size and broader dealer sponsorship of the transaction. Larger issues may

qualify for inclusion in the broad bond indices, such as the Barclays Capital U.S.

Aggregate Bond Index, which has a minimum outstanding size of $250 million for

inclusion in the index. For these reasons, the funding group at Fannie Mae strongly

encourages this type of coordination among its underwriting dealers.

Fannie Mae issued approximately $309.3 billion callable medium-term notes(MNs) in 2010 via the reverse inquiry process. As mentioned earlier, Fannie Mae is

focused on the issuance of callable MNs that are $250 million or larger issue sizes

with multiple dealer underwriters. Terefore,figure 1 illustrates, of the total $309.3

billion callable MNs, $69.7 billion were issued with at least two dealer underwriters

and in 139 transactions.

FANNIEMAECALLABLEDEBTINCLDED

INBONDINDICE

Fannie Mae callable debt securities are included in most of the major domestic and

international bond indices incorporating U.S. dollar high credit quality securities, suchas those published by Citigroup, Barclays Capital, Bank of America Merrill Lynch, and

others. Tis is of particular benet to those investors who determine their allocations to

various xed-income asset classes in their portfolios based on the composition of an

index.

6 FannieMaeCallableDebtReverse InquiryProcess


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YIELDCALCLATION

When calculating the yield or internal rate of return (IRR) of a callable structure, there

are three primary methods that an investor may use: yield-to-maturity, yield-to-call, and

yield-to-worst. When making purchase decisions based upon yields, it is important to

understand which of the three methods has been used in deriving the stated yield and

how changes in the yield curve will aect the nal yield performance of the security.

Yield-to-maturity

Te yield-to-maturity calculation assumes that the debt security is not called and the

investor holds the bond to its nal maturity date. Te yield is calculated from the cash

ow at maturity and the periodic interest payments generated by the bond (reinvested

at a rate equal to the bonds yield-to-maturity). When prevailing interest rates are

higher than the coupon on the bond, it is assumed that the issuer will not call the

bond. Under these circumstances, yields are commonly quoted using the yield-to-

maturity method.

Yield-to-call

Te yield-to-call calculation assumes that the bond is called on the next eligible call date.

Te yield is calculated from the cash ows of the coupon payments plus the cash ow of

the redemption proceeds at the time of the call. When prevailing interest rates are lower

than the interest rate on the issue, it is assumed that the issuer will call the security.

Accordingly, in such circumstances, yields are sometimes quoted on a yield-

to-call method.

Yield-to-worst

A more conservative alternative to the yield-to-call method is the yield-to-worst

method. Many bonds are continuously callable after their rst call date (American-style

call feature). Because of the uncertainty of the call date, the yield-to-worst method was

developed. o derive a yield-to-worst, a yield-to-call is calculated for the initial call date

and each coupon payment thereafter. Additionally, a yield-to-maturity calculation is

also performed. Te yield-to-maturity calculation and all of the yield-to-call calculations

are then reviewed with the lowest yield from the group designated as the yield-to-worst.

YId CCTIons fo fnnI M C bs

YieldCalculationsForFannieMaeCallables 7


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PRICINGFRAMEWORKOPTION-ADJTEDPREAD

(OA)ANALYI

Callable debt is usually priced and evaluated using an OAS framework similar to that

used for other option-embedded securities with cash ows that are sensitive to changes

in interest rates. Because a callable debt security consists of a bullet component and a

call option component, OAS provides investors with a methodology to analyze a

callable debt security by factoring out the yield premium associated with the call

option. Te OAS of a callable debt security is expressed as a spread over a noncallable

yield curve such as Fannie Maes noncallable Benchmark Notes yield curve, the

reasury yield curve, or the interest rate swaps curve. Te OAS analysis framework is

based on a forward rate curve derived from the noncallable yield curve employed,

volatility assumptions, and the current security price. An OAS model generates the

average spread over the forward curve under a number of possible future interest rate

paths. For many xed-income investors, OAS is one of the more useful measurements

for assessing value in a callable debt security. Investors also compare the OAS of a

callable debt security to the option-adjusted or bullet spreads of other xed-income

securities in analyzing investment decisions and relative value.

o calculate an OAS that most accurately captures the value of a callable debt

security, investors must incorporate their views with respect to future interest ratevolatility. Volatility represents the amount of interest rate uctuation that is expected

over a given period of time. Te expectation of future rate volatility may be inuenced,

or determined in part, from historical measures of volatility. A more detailed discussion

of the measurement and impact of interest rate volatility as it relates to Fannie Mae

callable debt is provided later in this section. Meanwhile, Bloomberg oers an easy and

eective method for calculating the OAS of a specic callable debt security. Investors

with access to Bloomberg terminals can analyze option-adjusted spreads through the

OAS1 screen by entering a yield curve, implied volatility and price, and setting the

Calculate box to O for OAS. Te price or volatility can be calculated instead of the

OAS just as easily by plugging in the remaining two parameters and changing theCalculate box accordingly.

Any standard OAS calculator will return a value for implied volatility, price, or the

OAS, given the other two parameters and the yield curve as inputs. Tese values are

quickly accessible and easy to interpret, with no assumption on prepayments or other

models for cash ows.

8 YieldCalculationsForFannieMaeCal lables


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BLOOMBERGAOACREENFORCALLABLE

MEDIM-TERMNOTE

Securities Industry and Financial Markets Association (SIFMA) guidelines were

introduced in late 2003 for pricing and trading European-style callable U.S. agency

debt securities. Fannie Mae believes this development further enhances the transpar-

ency and liquidity of callable debt securities in both the primary and secondary

markets. Te SIFMA guidelines incorporate skew into the volatility assumption and

recommend the use of the Black Scholes model as the OAS-to-price calculation

convention. Te volatility skew adjustment corrects the value of those options that are

not at-the-money. Bloombergs AOAS screen incorporates the SIFMA guidelines and

enables investors to value Fannie Mae callable debt securities relative to an up-to-the-

minute Fannie Mae constant maturity yield curve derived from a live noncallable

Benchmark Securities yield curve.

Te guidelines recommend the use of a single credit issuer specic constant

maturity curve, and the relevant swaption volatility to price the callable bond on an

OAS basis. For example, in analyzing a Fannie Mae callable debt security, Fannie

Maes noncallable Benchmark Securities constant maturity yield curve should be used.

Te criteria is limited to callable securities that have European-style (one-time) call

options, and are callable at par only on the call date. Also, they are only callable on acoupon date.

o perform analyses on these securities, investors may change several of the variables

while in AOAS, including the Yield Curve, At-the-money Volatility, OAS, Price, and

Settlement Date. Only the Skew Adjusted Volatility and the Forward Strike rate may

not be over ridden. Additionally, AOAS requires that the investor enter either an OAS

or Price to solve for the other, i.e. enter OAS to solve for Price and vice versa. Te

securitys CUSIP may be used to bring the security into AOAS for analysis by typing

the Fannie Mae CUSIP number AOAS . Pleae ee figure 2.



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Detailsofeachvariableareprovidedbelow:

The Ctat Maturity Yiel Curve: Te default constant maturity yield curve in

AOAS for Fannie Maes callable debt is Fannie Maes noncallable Benchmark Securities

constant maturity yield curve. For other agencies European callable notes, the default

yield curve is typically their respective bullet yield curve or, alternatively, the swaps

curve. Te maturities dening the curve include 3-months, 6-months, 1-year, 2-years,

3-years, 4-years, 5-years, 7-years, 10-years, 20-years and 30-years. Te entire

Benchmark Securities yield curve is fed to Bloombergs AOAS screen, except for the

20-year maturity yield. In the case of the 20-year maturity yield, Bloomberg will use

a straight-line interpolation between 10-year and 30-year bullet Benchmark yields.

Te yields provided on Bloombergs AOAS screen are populated by using the

average bid-side yields from contributing broker-dealers for Fannie Mae Benchmark

Notes. Tese yields are then designated to corresponding maturity points on Fannie

Maes constant maturity yield curve and are continually updated throughout the

business day. Yields may be refreshed within the AOAS screen by selecting the refresh

button on the bottom-right of the screen. Te underlying securities that make up the

constant maturity yield curve may be viewed in Bloomberg by typing AGPX .

Te column labeled Adjust shows the constant maturity adjustment spreads. Te

adjustment spreads are calculated by subtracting the constant maturity yield from theactual yield for the same maturity point. Te constant maturity calculation used for

AOAS has been recommended by the SIFMA.

Investors can also use the AOAS screen to evaluate a security with the swaps curve

or the constant maturity reasury curve by substituting these curves for the Benchmark

Securities default yield curve.

t-the-mey Vlatility: Within the AOAS screen, the default volatility will be the

mid-market at-the-money volatility for a comparable European-style option as quoted

by the inter-dealer brokerage rm ullett & Prebon. Te ullett & Prebon swaption

volatilities are found in Bloomberg by typing SV 1 2 , forUnited States Dollar Swaption Volatilities or on the Reuters iCap page 19902. Te

ullett & Prebon swaption volatilities are updated throughout the day and fed directly

into Bloomberg. Investors may override the default volatility assumption that appears

in AOAS by changing it to any desired value.

10 YieldCalculationsForFannieMaeCallables


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skew jute Vlatility: Te at-the-money volatility input in the AOAS model is

adjusted for skew resulting in a Skew Adjusted Volatility that more accurately reects

current market conditions. Te at-the-money volatility input in AOAS is adjusted

according to a normalized adjustment factor developed by Blyth and Uglum of Morgan

Stanley. Te Skew Adjusted Volatility gure that is displayed in AOAS cannot be

overridden but may be turned o as indicated by Use Skew Adj Vol eld. However,

the skew variable may be changed manually but is defaulted, per SIFMA guidelines, to

1.00. Any change in the skew variable (from 1.00) will result in a dierent calculated

skew adjusted volatility.

frwar strike: Te Forward Strike rate shown in AOAS is implied from the

Benchmark Securities yield curve and is also adjusted up and down by the OAS

assumption. Te forward yield is implied by the current yield curve for the period

beginning on the exercise date and ending on the maturity date of the underlying

swap. Te Forward Strike rate that is displayed in AOAS is not a variable that can

be overridden.

settlemet date: Te settlement date for a new issue defaults to the appropriate

date at the announcement of each issue. For a new issue, Fannie Mae will input thesettlement date. For outstanding issues or reopenings, the default settlement date in

Bloomberg will need to be veried by the investor. Te SIFMA guidelines recommend

that the settlement date is not to be greater than three days.

os a Price: Te OAS of callable debt securities will be priced on an OAS basis

relative to the noncallable Benchmark Securities yield curve. An investor can input

an OAS at which a specic transaction is being marketed or an OAS at which an

investor is interested in buying or selling a callable debt security to get the correspon-

ding dollar price.

Conversely, the desired dollar price of a callable debt security may be entered to

obtain the corresponding OAS. Te assumption for the above calculation is that the

volatility being used has been set to a desired value but the default volatility is the

European swaption volatility. It is also possible for the user to calculate an implied

volatility using the AOAS screen for a given price and OAS level.



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By analyzing its components, investors are able to assess the value of callable debt.

o illustrate this point, we use a par-priced, new issue 5 non-call 2-year (5nc2)

Fannie Mae European-style callable debt security, which has a ve-year maturity,

two-year lockout, after which it is redeemable at par, as the example in the following

discussion. Similar explanations and analogies can be made for other callable structures

that Fannie Mae issues.

An investment in a par-priced 5nc2 callable new issue can be thought of as the

purchase of a 5-year bullet with a coupon equal to the callables coupon (5-year bullet

component) and the simultaneous sale of an option to call a 3-year bullet two yearsfrom issue date (call option component). Note that the option is being sold on a

forward bond. Te investor has sold Fannie Mae an option to redeem a three-year

bond two years from now. Te value of the callable is the dierence in the value

between these two components:

Price5nc2callable= Price5-yearbullet PriceCalloption

KEYPOINTONTHEYIELDCRVE

Te value of the 5-year bullet component depends on the Fannie Mae 5-year bulletyield. Te call option embedded in a European-style 5nc2 callable depends on the value

of a forward asset, e.g., a 3-year bond beginning in 2 years (termed for convenience

a 5/2 forward). Te value of the 5/2 forward is in turn derived from the yields of a

5-year bullet and a 2-year bullet.

Tis analysis of the key points on the yield curve can also be used for callable debt

with an American-style call feature. Te value of the option depends partly on the

5/2 forward, but because it has a continuous call option, other points on the curve

must also be analyzed. Tus, the value of the American-style call option would also

depend on the 5/3 forward, the 5/4 forward, and all other forward points within

the 2- to 5-year call window.

nYzInG TH CoMPonnTs of Cb dbT

12 AnalyzingtheComponentsofCallableDebt


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DRATIONANDCONVEXITYCHARACTERITIC

Te eective duration of a callable debt security falls between the eective durations

of bullets maturing on the call date and the maturity date of the callable debt security,

respectively. As yields decline, the duration of a callable debt security shortens and

approaches the duration to call. As yields rise, the duration lengthens and approaches

the duration at maturity. Although lower yields result in higher prices for xed-income

securities, with callable debt securities, the percentage price change will be less than for

equal duration bullets in a falling interest rate environment due to the increased likeli-

hood of the bond being called. Tis characteristic of a callable debt security is known

as negative convexity. Tese negative convexity characteristics are also found in most

mortgage securities and some types of asset-backed securities that have embedded options.

Fannie Mae typically issues callable debt securities with various eective durations and

convexities. Fannie Mae also oers a diverse variety of structures in terms of maturities,

call lockouts, and resulting durations and convexities to investors . figure 3 illustrates

the convexity and duration proles for several of Fannie Maes most commonly issued

European-style callable debt structures.

Fannie Mae

also ofers

a diverse

variety o

structures in

terms o

maturities,

call lockouts,

and resulting

durations and

convexities to

investors.

AnalyzingtheComponentsofCallableDebt 13

Negative Convexity Segmentof a Callable Debt Security

Yield

Positive Convexity of aNoncallable Debt Security

Price

100

Price/Yiel elatihip r a Callale det security

a a ncallale det security


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IMPACTOFNEGATIVECONVEXITYON

FANNIEMAECALLABLE

Convexity is a feature of xed-income securities that has a direct impact on a securitys

performance and is useful for comparing bonds. If two bonds oer the same duration

and yield but one exhibits greater convexity, changes in interest rates will aect each

bond dierently. Te price of a bond with negative convexity is less aected by move-

ments in interest rates than a bond that displays positive convexity or does not have

option embedded features. Comparing two securities with the same nal maturity, a

callable security with a shorter lockout period would have greater negative convexity.

For example, for a 5 non-call 3-year security, the longest possible maturity is 5 years and

the shortest possible maturity is 3 years. As rates increase, the price-yield behavior of

the callable security approaches that of a 5-year bullet because the call options value

decreases as the yield moves higher. Conversely, if rates decline, this callable bond

would exhibit negative convexity in that the security behaves more like a 3-year bullet

rather than a 5-year bullet because the likelihood of the security being called increases.

A 5 non-call 1-year security would exhibit negative convexity as well, but this bond

would behave more like a 1-year bullet as yields fall. Te price sensitivity for a 1-year

bullet would be less than the price sensitivity for a 3-year bullet for the same change in

yield. Terefore, as the yield falls on the 5 non-call 1-year security, it would exhibit

greater negative convexity than would the 5 non-call 3-year security.

Te length of the lockout period also impacts the performance of callable debt

securities. If investors accept shorter lockout periods they typically obtain higher yields

because they are exposed to the risk that their securities could be called for a longer

period of time. Since the value of a callable debt security is impacted by the value of the

call option, the length of the lockout option aects the convexity prole of the security.

It is important to point out that negative convexity is a characteristic of callable debt

that the investor has the ability to alter by using Fannie Maes reverse inquiry process.



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IMPACTOFINTERETRATEVOLATILITYON

FANNIEMAECALLABLE

Interest rate volatility is a market variable that has a signicant impact on the initial

pricing and returns of Fannie Mae callable debt. Expectations of future interest rate

volatility, often referred to as implied volatility, result in changes in the valuation of the

embedded option. For example, expectations of higher future volatility will imply higher

yields for all callable debt. Alternatively, expectations of lower volatility imply the

opposite. Many investors base their predictions of future interest rate volatility on their

perspective of historical interest rate volatility. In addition, forecasts on the fundamental

health of the economy can be of value in developing predictions of future interest rate

volatility. A commonly used measure of volatility for Fannie Mae callable debt (particu-

larly European or one-time callables) is the volatility for a corresponding swaption in the

over-the-counter derivatives market.

Investors often buy a callable security because they believe that actual future realized

volatility will be lower than that implied by the price/yield at which they are able to

purchase the security. In this way the level of implied volatility at the time of buying a

callable security can be a key relative value indicator for an investor.

IMPACTOFYIELDCRVECHANGEANDREHAPINGONFANNIEMAECALLABLE

Te initial pricing and future returns of Fannie Mae callable debt are also determined

in part by the initial yield curve and changes in the yield curve over time. Te returns

of callable debt in a variety of hypothetical future curve shift scenarios (e.g., parallel,

attening, and steepening) are described below. Te key points on the yield curve that

aect callable debt securities are those corresponding to a securitys call and maturity

dates. For instance, the Fannie Mae 5nc2 callable debt security would be aected

most signicantly by 5-year and 2-year yields. Te investor could obtain from some

combination of 5-year and 2-year bullets an average eective duration equal to the

option-adjusted duration of the 5nc2 callable debt security. As a result, the investor

in a 5nc2 callable debt security can be thought to have synthetic long positions in

2-year and 5-year bullets. Tis position is often referred to as a synthetic barbell.



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Impactoftheshapeoftheinitialyieldcurveonnewissuepricing

Te nominal spread of a 5nc2 callable debt security over the 5-year U.S. reasury yield

increases and declines for two main reasons. One reason is due to changes in perceived

interest rate volatility, as explained above, and the other is the slope of the yield curve

between the 2- and 5-year points. Te value of the 5nc2 callable debt security is equal

to the value of the 5-year bullet minus the value of the call option. A steep yield curve

implies that expected future yield levels are higher than current levels. Because a call

option is less likely to be exercised in a high interest rate environment, a steeper yield

curve between 2 and 5 years makes the call option embedded in a 5nc2 callable debt

security less valuable and, therefore, results in a lower nominal spread for the 5nc2

callable debt security. Conversely, a atter curve results in a more valuable call option

and a higher nominal spread for the 5nc2 callable debt security. Accordingly, investors

typically demand higher nominal spreads for callables in at yield curves when the

call option is more valuable and lower spreads in steep yield curves when the call

option is less valuable.

Impactofvariouschangesinyieldcurveontotalreturns

Interest rates and the yield curve can be expected to change over time through

parallel, attening, and steepening shifts as well as other more complex types of

yield curve changes.



20/37

Impactofyieldcurvechangesontheperformanceofpremium

anddiscountcallables

A callable debt securitys sensitivity to changes in market variables depends on whether

the call option is in-the-money, at-the-money, or out-of-the-money. Investors can

determine whether a call option is trading at a premium or a discount by comparing the

coupon of the callable to the par forward rate implied by Fannie Maes bullet curve.

For example, the coupon of a 5nc1 would be compared to the 1-year into 4-year par

forward rate. For a premium callable, which has a coupon that is higher than the

implied forward rate, the embedded option is in-the-money. Consequently, the

premium callable will most likely trade on a yield-to-call basis due to the likelihood

that it will be called. For a discount callable, which trades below par, the embedded call

option is out-of-the-money and will generally trade like a bullet to maturity. Te more

a premium callable moves into the money, the more it trades like a bullet with a

maturity comparable to its lockout period. Conversely, the more a discount callable

moves out-of-the-money, the more it trades like a bullet with a maturity equal to its

nal maturity. Tese characteristics of premium and discount callables make their

prices less sensitive to changes in market variables. At-the-money callables, which trade

at or near par, exhibit the most sensitivity to changes in interest rates and volatility

because there is more uncertainty associated with the embedded call option.



21/37

Investors buy callable debt for several dierent, though related, reasons. Most often, the

goal is to enhance yield or returns in a high credit quality security by taking a specic

view on future interest rates or volatility.

Callale et ecuritie eale ivetr t ell iteret rate pti i they

cat participate i oTC erivative. Many investors are not able to participate

in the OC options market and, therefore, invest in Fannie Mae callable debt as a way

to sell options that they would not be able to do otherwise. Te variety of structures that

Fannie Mae issues make it possible for these investors to use callables for this purpose.

Callale et ecuritie geerally have hitrically prvie higher

yiel tha callale et ecuritie maturig either the call ate

r the maturity ate. Te incremental spread oered by callables over comparable

maturity bullet securities leads to a greater yield at maturity because of the call option

embedded in the callable security. However, even in the event the security is called

before the maturity date, the investment will often provide a greater yield than a bullet

maturing on the call date.

Ivetr uy callale t take avatage high os level. As men-

tioned earlier, given that a callable debt security consists of a bullet component and a

call option component, OAS provides an investor with a methodology to analyze a

callable debt security by factoring out the yield premium associated with the call

option. Te OAS of a callable debt security is expressed as a spread over a noncallable

yield curve such as Fannie Maes noncallable Benchmark Notes yield curve, the reasury

yield curve, or the interest rate swaps curve. Investors gain from the alternative OAS

levelsrelative to Fannie Mae noncallable securities or other corporate securities.

Ivetr ca have expure t the vlatility callale.When implied

volatility reaches historically high levels, investors may invest in agency callables if they

expect a reduction in implied volatility levels.

The call pti callale et i much eaier t aalye tha the

prepaymet ehavir mrtgage-relate ecuritie. Fannie Maes

economic decision to call its securities is an ecient and uniform call decision that is

generally based on the level of interest rates and where Fannie Mae can issue similar

duration debt at a lower option-adjusted spread. In addition, given the stated nal

maturity date of a callable debt security, there is no extension risk with callable debt.

WHY InVsTos bY Cb dbT

18 WhyInvestorsBuyCal lableDebt


22/37

For mortgage securities, investors must evaluate much more complicated and uncertain

call decisions requiring prepayment forecasts, many of which dier substantially among

investors even for mortgage loans of similar characteristics. Tese prepayment models

usually include a host of economic as well as noneconomic factors, and have historically

diered substantially from actual prepayment experience. Terefore, many investors

have found the more predictable nature of the call decision along with the structural

benets and attractive spreads of Fannie Mae callable debt to be an appealing alterna-

tive to mortgage related securities.

faie Mae callale et ha hitrically prvie attractive yiel i

th teepeig a atteig yiel curve evirmet. In a rising yield

curve scenario, investors may choose to buy callables to outperform noncallable

securities of the same maturity. Tis is because they expect the callables not to be called

and, therefore, to outperform noncallable securities of the same maturity. In a stable or

declining interest rate scenario, or an upward sloping yield curve, investors may expect

their investments to be called, and therefore buy callables to receive a higher yield up to

the call date versus a bullet security.

Iexe ivetr purchae agecy ullet a callale et t matchthe hare thee ecuritie i majr xe-icme iice. Agency debt

is a sizable component of the major xed-income indices. Many indexed investors

include callable agency debt in their portfolios to potentially match or outperform

their benchmark xed-income index.

faie Mae ha the exiility t tructure callale et with cup

paymet t meet ivetr pecic ee. Most often, securities are issued

with semiannual coupon payments, but the frequency of coupon payments can be

structured to occur monthly, quarterly and annually. Fannie Mae also oers the

greatest diversity of agency callable debt in terms of maturity dates, lockout periods,

call features and interest payment dates.

WhyInvestorsBuyCallableDebt 19


23/37

As discussed, the callable debt redemption policy for Fannie Mae callable debt typically

has one of four call features:

urpeathe issue can be called on only one, pre-determined date.

bermuathe issue is usually callable only on a pre-determined schedule of dates.

mericathe issue can be called on the initial call date or any time thereafter

until maturity.

Caarythe issue is callable for a designated period of time on a pre-determined

schedule of dates. Once the designated call period concludes, the issue is no longer callable.

When a Fannie Mae callable debt issue has reached its call or redemption date, Fannie

Mae generally can call the issue in whole or in part. As a matter of practice, Fannie Mae

generally calls its securities issues in whole. Fannie Maes callable redemption policy is

transparent and relatively easy to understand. It is in the companys interest that

investors of Fannie Maes callable debt clearly understand why and how Fannie Mae

callable debt is redeemed.

Fannie Maes economic decision to call its securities is an ecient and uniform call

decision based on the level of interest rates.

For instance, in an environment of falling interest rates, callable securities that havepassed their lockout period are more likely to have the call option exercised. Below is

an example of the process Fannie Mae uses to determine whether or not to call a debt

security that has entered its call period. An investor relying on this description should

be able to develop a good idea of whether or not a security will be called, though

perfect accuracy in such predictions cannot be assured. Predicting the call decision

requires knowledge of the current level of yields and spreads for callable and noncall-

able Fannie Mae debt.

Fannie Mae performs a theoretical calculation employing a hypothetical par-priced

currently callable security. If the yield of the hypothetical issue is lower than the yield

of the outstanding issue, the implication is that the outstanding issue could be called.

Te yield for this security is calculated using option-adjusted spread models. Te

theoretical yield-saving calculations are made by referring to the prevailing yield curve,

so that an investor using the same process should be able to deduce as to the likelihood

that the callable debt security will be called. Tis yield would be compared to the yield

of the outstanding callable that is a candidate for redemption, with the latter yield

being calculated assuming a price equal to its call price, typically at par.

C PoCss

Fannie Maes

callable

redemption

policy is

transparent

and relativelyeasy to

understand.

20 CallProcess


24/37

As stated earlier, Fannie Mae generally exercises the call option strictly on economicgrounds. If the current interest rate environment supports issuing callable debt at lower

coupons than existing outstanding callable debt, Fannie Mae will call the higher

coupon outstanding callable debt and replace the outstanding issue with a new issue

that has similar characteristics to the old issue.

In practice, Fannie Mae may replace callable debt that has been called with new

debt, either callable or noncallable, that diers in maturity or call lockout period. Such

a dierence between the new and old issues may be dictated by Fannie Maes current

asset/liability management needs, by relative value considerations relating to the funding

alternatives available or by investor demand. Occasionally, outstanding callable debt that

is called may not be refunded at all, particularly if mortgage liquidations are high, and

there is no need to replace the debt.

When Fannie Mae determines that the issue should be called, it gives notice in the

manner set forth in the terms of the securities. Te time between when notice of a call

is given and when redemption of principal occurs is 10 calendar days.

It is Fannie Maes general practice to redeem principal on a business day (as dened

in the terms of the applicable securities). An exception is that if the interest payment

date is on a non-business day, and the call date of a callable debt security falls on this

same non-business day, then the bond may be called on that day. Following standard

industry practice, the redemption payment is made on the subsequent business day.

Interest on the principal amount redeemed is paid up until the date xed for the

redemption. If payment is delayed because the date xed for redemption is not a

business day, additional interest on the principal amount redeemed is not payable

as a result of the delay. Of course, the terms of any particular issue of securities are

governed by the applicable documents establishing such terms, and may dier from

the above information.

Callale det securitie Calle Cmparale faie Mae det

Call style CsIP settle mut Cup Maturity Call date structure Ty sprea structure Yieldate Calle date (p)

European 3136FJ4N8 2/18/10 $100M 3.10% 8/18/15 8/18/10 5.5nc0.5 T5+28 5-yearbullet 1.88%

Bermudan 3136FJ2Y6 2/18/10 $100M 3.05% 2/18/15 8/18/10 5nc0.5 T5+46 4.5nc0.25Bermudan 2.06%

American 3136FMTE4 5/18/10 $100M 5.00% 5/18/20 8/18/10 10nc0.25 T10+116 9.75nc1-dayAmerican 4.09%

CallProcess 21


25/37

FANNIEMAEWEBITE

Fannie Mae provides numerous tools and information resources for callable debt

investors on its web site. Te companys web site provides the most accessible means

to monitor the call status of the callable debt securities in which they have invested

or obtain legal disclosures such as the Universal Debt Facility Oering Circular or

Pricing Supplements. Fannie Maes web site also provides two reports, that are updated

daily, which detail the companys callable debt securities issued and callable debt

securities outstanding.

CallMonitor

Te Call Monitor allows investors to retrieve information on recently called securities

or to view currently callable securities. Te Call Monitor allows market participants to

examine Fannie Maes recent call activity. Using the Call Monitor, debt investors can

view recently called securities for the trailing three months as well as debt securities that

are currently in their call period on any particular day. Call Monitor is available on the

Fannie Mae web site under Debt Securities => Call Monitor.

niversalDebtFacilityOfferingCircular

Te Oering Circular for Fannie Maes Universal Debt Facility outlines the general

terms of Fannie Mae debt securities. Te Oering Circular includes extensive informa-

tion on Fannie Mae debt securities including a general description of funding

programs, risk factors, clearance and settlement procedures, and distribution methods.

Te Oering Circular is located on the Fannie Mae web site under Debt Securities =>

Debt ools and Resources => Fannie Maes Universal Debt Facility.

22 CallProcess


26/37

Pricingupplements

In addition to the Universal Debt Facility Oering Circular, debt investors should

also refer to pricing supplements for specic issues of Fannie Mae debt securities in

which they invest. Fannie Mae discloses detailed information on individual debt

securities through these pricing supplements. Certain securities terms such as pay-

ment dates, maturity dates, payment currency, principal amounts and interest

specications are included in the pricing supplements. Te supplements also provide

identication numbers, listing applications, pricing dates, settlement dates and dealer

underwriting commitments.

Pricing supplements for outstanding noncallable and callable debt securities can be

retrieved on the Fannie Mae web site by going to Debt Securities => Debt ools and

Resources => Document Search. Agency market participants can locate specic pricing

supplements by CUSIP number.

CallProcess 23


27/37

annie Mae oers a wide variety of high quality callable debt securities with

maturities ranging from one year to thirty years and call lockout periods

ranging from three months to ten years or longer. Investors purchase these

securities to receive enhanced yields relative to noncallable securities in

exchange for taking the risk that the securities may be called by Fannie Mae prior to

their maturity date. Investors may buy these securities specically as a way to take a view

on interest rate volatility, i.e., if they expect future interest rate volatility to be low they

might buy callables that are priced at higher implied interest rate volatility levels.

Investors may buy Fannie Mae callable debt securities in order to benet from a specicview of how the yield curve shape may change in the future. For instance, investors who

believe that the yield curve may atten may buy a callable security to enhance returns

relative to barbell or bullet portfolios of duration similar to that of the callable.

Fannie Mae callable securities are most often issued as callable notes through a

reverse inquiry process. Most of the investor segments active in Fannie Mae senior

noncallable debt securities are also active in callable notes. Commercial banks, fund

managers, central banks and state and local authorities are particularly active partici-

pants in this type of security.

Fannie Mae is committed to providing its investors with a diverse array of callable

debt structures through its issuance initiatives on an ongoing basis. Te company iscommitted to innovation in the market for callable debt and works diligently to

incorporate the needs of its investors and make enhancements to its callable debt

issuance activities.

ConCsIon

F

24 Conclusion


28/37

GossY

merica-style Call feature: Te call option may be exercised on any business day

after an initial lockout period. Tis type of call feature is also referred to as a continu-

ous call.

os (gecy opti-jute sprea): A new model for pricing and

analyzing callable debt securities with European calls. AOAS refers to the yield

premium over an agency yield curve instead of the more traditionally employed

reasury or interest rate swaps yield curves.

bermua-style Call feature: Te call option may be exercised semiannually on

the coupon payment dates after an initial lockout period. Tis type of call feature is

sometimes referred to as a discrete call.

Callale det: A debt security whose issuer has the right to redeem the security prior

to its stated maturity date at a price established at the time of issuance, on or after a

specied date. Fannie Mae callable debt securities are always redeemed at par.

Call feature: Te type of call option embedded in a callable security (i.e., American,

Bermudan, Canary or European).

Call opti: An option granting the holder the right to buy the underlying asset on

(or before) a specied date at a specied (strike) price.

Call ik: Te risk to an investor that a given callable debt security will be redeemed

prior to its nal maturity date, thus aecting expected cash ows and consequently

the yield on the security.

Caary-style Call feature: A call feature that combines a Bermudan-style call

option and a European-style call option.

Cvexity: A volatility measure for bonds used in conjunction with modied

duration in order to measure how the bonds price will change as interest rates change.

It is equal to the negative of the second derivative of the bonds price relative to its

yield, divided by its price. For example, since a noncallable bonds duration usually

increases as interest rates decrease, its convexity is positive.

GossY

25 Glossary


29/37

Creit ik: Te possibility that the issuer or another party may have its credit rating

downgraded by a rating agency; may experience changes in the markets perception of

its creditworthiness; or may default on its nancial obligations to the investor.

durati: Te weighted average maturity of the present values of the securitys

cash ows. It is used as a measure of the sensitivity of the value of a security to changes

in interest rates. Te greater the duration of a security, the greater its percentage

price volatility.

urpea-style Call feature: Te call option may be exercised on a single date at

the conclusion of the initial lockout period.

Hitric Vlatility (ealie Vlatility): A statistical measure of a securitys past

price movements. It is calculated by using the market price of the option and solving

for volatility.

Implie Vlatility: A measure of a securitys expected volatility as reected by the

market price of the traded options on that security. Te theoretical price of an option is

a function of the underlying price, strike price, historical volatility of the underlying,the risk-free rate, and time to expiration. Implied volatility appears in several option

pricing models, including the Black-Scholes Option Pricing Model.

Iteret ate ik: Te risk that the value of a bond will depreciate in response to

an increase in interest rates. An inverse relationship exists between bond prices and

yields for xed-income securities. In a rising interest rate environment, bond prices

will decrease and in a declining interest rate environment, bond prices will increase.

ckut Peri: A time interval, usually early in the life of a security, when a call,

conversion feature, or some other provision is not operative. A callable security cannot

be called during this period of time.

Maturity date: Te date on which the life of a nancial instrument ends through

cash or physical settlement or expiration with no value.

Glossary 26


30/37

opti: Te right to buy or sell an asset at a specied price on, before, or after a

specied date.

opti-jute sprea (os): A reference tool for comparing alternative

debt securities that contain embedded options. OAS refers to the yield premium over

comparable U.S. reasury securities that a callable debt security would have if it were

noncallablethat is, if the value of the embedded option in the callable debt security

were removed from the value of the debt security.

ep (epurchae greemet): An agreement between a seller of securities and

a buyer, whereby the seller agrees to repurchase the securities at an agreed upon price

and at a stated time.

evere Iquiry: A method of initiating issuance of debt securities whereby an

investor consults with a broker/dealer and then the broker/dealer approaches an issuer

with a proposal for a specic security issuance that will meet the investors needs.

sprea: ypically, in the context of pricing debt securities, the dierence in

percentage or basis points between the yield of a non-U.S. reasury debt securitybeing priced and the yield of a comparable U.S. reasury security. Also refers generally

to the dierence in yields or coupons between any two debt securities. Usually noted

in basis points.

Vlatility: Te relative rate at which the price of a security moves up and down.

Volatility is found by calculating the annualized standard deviation of daily change

in price.

Yiel: Te annual rate of return on an investment, expressed as a percentage. Yield

calculation for notes and bonds is based on the coupon rate, length of time to maturity,

and market price, assuming the coupon paid over the life of the security is reinvested

at the same rate.

Yiel Curve: A curve that illustrates the relationship between yields and maturities

for a set of similar bonds at a given point in time.

27 Glossary


31/37

Yiel-t-Call: Te internal rate of return on a callable bond in the event that the

bond was redeemed by the issuer on the next available call date.

Yiel-t-Maturity: Te internal rate of return on a callable bond or a xed rate

security if the bond was held until the maturity date.

Yiel-t-Wrt: Te lowest of all yield-to-calls or the yield-to-maturity.

We deal in one

asset type

residential

mortgages andmanage two types

o risk on that

asset interest

rate and credit

risk.

Glossary 28


32/37


33/37

30 Figures

fg 2.

loombergcreenFannieMae4N1uropean-styleallableNote

valuatedelativetotheNoncallableenchmarkurve

This exhibit is the SIFMA pricing model as it appears on Bloomberg using Fannie Maes recently issued1.200% 4 noncall 1-year European-style callable note due November 3, 2014.

The noncallable Bench-

mark Securities yield

curve and associated

constant maturity yield

adjustment spreads are

fannie Mae Benchmark

Securities yield curve

provided by Bloomber

Aency Composite

AgPX spreads.

esultindollar price

esultinOAS

p-to-date relevant mid-market uropean swaption

volatility imported rom Tullett Prebon


34/37

31 Figures

fg 3.

Durationandconvexityprofilesforthemostcommon

uropean-stylecallabledebtstructures.

0

-0.3

-0.6

-0.9

-1.2

-1.5

-1.8

0 2 4 6 8 10 12 14

Source: Fannie Mae

As of December 31, 2010

2NC1

3NC1

5NC1

7NC1

5NC3

5NC2

7NC2

10NC2

7NC4

7NC3

10NC4

10NC3

15NC5

coNvexITy

DTIN


35/37

DICLAIMER

Fannie Mae securities are more fully described in applicable oering circular, prospec-

tuses, or supplements thereto (such applicable oering circular, prospectuses and

supplements, the Oering Documentation), which discuss certain investment risks

and contain a more complete description of such securities. All statements made herein

are qualied in their entirety by reference to the Oering Documentation. An oering

only may be made through delivery of the Oering Documentation. Investors consid-

ering purchasing a Fannie Mae security should consult their own nancial and legal

advisors for information about such security, the risks and investment considerations

arising from an investment in such security, the appropriate tools to analyze such

investment, and the suitability of such investment in each investors particular circum-

stances. Te Debt Securities, together with interest thereon, are not guaranteed by the

United States and do not constitute a debt or obligation of the United States or of any

agency or instrumentality thereof other than Fannie Mae.


36/37

Our Business Is Te American Dream

At Fannie Mae, we are in the American

Dream business. Our Mission is to tear

down barriers, lower costs, and increase

the opportunities for homeownership and

aordable rental housing for all Americans.

Because having a safe place to call home

strengthens families, communities and

our nation as a whole.


37/37

3900 Wisconsin Avenue NW

callable brochure

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