an introduction to callable Debt Securities

Table of Contents

1 Introduction

2 Characteristics of Callable Debt

5 Fannie Mae Callable Debt – Reverse Inquiry Process

7 Yield Calculations for Fannie Mae Callables

12 Analyzing the Components of Callable Debt

18 Why Investors Buy Callable Debt

20 Call Process

24 Conclusion

25 Glossary

29 Figures
 I n t r o d u cti o n

F
annie Mae is a leader in the $11.5 trillion U.S. home mortgage market. The
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. To fulfill 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. To effectively manage the interest rate and prepayment
risks inherent in a mortgage portfolio, Fannie Mae issues noncallable and callable debt
securities. Callable debt is one of the most important financial 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 company’s portfolio to
prepay more quickly. Fannie Mae can then redeem the company’s currently callable
debt to match the liquidations of the company’s mortgage assets, thus keeping the
duration of the company’s assets and liabilities closely in line.
Callable debt securities also offer investors the opportunity to potentially earn
enhanced returns in exchange for taking call risk or selling convexity. Fannie Mae takes
very seriously its role in being a flexible, responsive and efficient issuer of callable debt
securities and providing investors adequate information to facilitate trading and
investment of these securities. The company’s 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 Mae’s callable debt is brought
to market mainly through a daily “reverse inquiry” process involving investors, dealers
and Fannie Mae. Fannie Mae provides flexibility to investors seeking customized
structures on a reverse inquiry basis based on a need for a specific coupon, maturity
date, call date or call feature. Therefore, Fannie Mae issues a diverse group of callable
securities with a variety of final maturities and call lockout periods resulting in securi-
ties with a wide range of duration and convexity profiles. Different 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.

Introduction 1
Hh
C ead
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n ee r
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es sH eOF
r e C ALLABLE DEB T

CALLABLE D E B T Featu res

Three main structural characteristics of Fannie Mae callable debt securities are the
maturity date, the lockout period and the call feature.
The maturity date of a callable debt instrument is the latest and final 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.
The 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 first three years.
The call feature refers to the type of call option embedded in a callable security.
Fannie Mae Fannie Mae callable debt securities most often incorporate one of the following
call features:
issues callable n  annie Mae issues continuously callable or American-style callable debt which
F
debt instruments can be called after an initial lockout period until maturity date. The investor is
compensated for this continuous call feature by receiving a higher yield than on
with a variety comparable maturity noncallable debt in exchange for allowing Fannie Mae the
flexibility to call the security at any time after the lockout period, until the final
of maturity
maturity date, with the requisite amount of notice given to the investor.
dates along the n  annie Mae issues callable debt with a one-time or European-style call feature. This
F
yield curve. 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 flow uncertainty of
a continuous call structure. The 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  annie Mae issues Bermudan-style callable debt securities which are callable only
F
on a predetermined schedule of dates, usually on the coupon payment dates after
the conclusion of the lockout period. Investors benefit from the increased
predictability of cash flows. The 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.

2 Characteristics of Callable Debt

 n  annie Mae issues Canary-style callable debt securities which incorporate the
F
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. The 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.

CALLABLE DEBT STR UCT URE S

In addition to straightforward, fixed-rate structures, Fannie Mae has the ability to issue
callable floating-rate notes, callable step-up notes and callable zero-coupon notes.

Callable Floating-Rate Notes

Fannie Mae can issue callable floating-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. There are several floating rate
indices from which an investor can choose, including three-month Treasury Bills,
Prime, Daily Fed Funds, one-month LIBOR, three-month LIBOR, Weekly Fed Funds
and Weekly Constant Maturity Treasury. Depending upon the chosen index, various
index reset and interest rate payment frequencies are available.

Callable Step-up and Step-down Notes

Fannie Mae has the ability to issue callable step-up and step-down notes which are
variations of standard fixed-rate callable debt securities. They are structured with a
coupon that increases or decreases to a specified 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 first
step-up or step-down.

Characteristics of Callable Debt 3

 Callable Zero-Coupon Notes
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. The yield for a callable zero-coupon security is based on the difference
between the original discounted price and the principal payment at the call date.

4 Characteristics of Callable Debt

 FANN I E M AE C ALLABLE DEB T – RE V ERSE I N Q U I R Y P RO C ESS

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

attracted by the ease with which specific structures can be created to suit particular
investor needs, market views, and specifications. Investors can structure callable debt
securities designed to achieve certain coupon targets or purchase them based on relative
value considerations. Frequently, investors have specific maturity date and call date
requirements, and sometimes have preferences for specific call features (European-style,
American-style, Bermudan-style, or Canary-style).
Fannie Mae has the flexibility to structure callable debt to meet investor preferences The reverse
and works closely with underwriters to price, provide feedback to and execute callable
note structures with its dealer underwriters for investors. In addition, the reverse
inquiry process
inquiry process enables investors to obtain the structure of their preference in an is kept as flexible
efficient 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 as possible so as
the company’s asset/liability management needs. Since there is often no need to arrange
to enable investors
a simultaneous interest rate swap converting the callable issue into a floating rate
liability, it is more straightforward for dealers to underwrite Fannie Mae callables than to meet their
the callables of other issuers. This results in more efficient pricing and quicker
execution.
needs for callable
Investors who have interest in specific callable structures typically have discussions investments in
with 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 the most fair
to Fannie Mae by one or more dealers. Alternatively, sometimes a transaction is
and transparent
structured for a larger size than any single investor’s interest. This is because the dealer
observes a larger amount of general demand for that structure. Fannie Mae will in turn manner.
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. The 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.

Fannie Mae Callable Debt – Reverse Inquiry Process 5

 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.
Therefore, investors can obtain the benefit 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
(MTNs) in 2010 via the reverse inquiry process. As mentioned earlier, Fannie Mae is
focused on the issuance of callable MTNs that are $250 million or larger issue sizes
with multiple dealer underwriters. Therefore, Figure 1 illustrates, of the total $309.3
billion callable MTNs, $69.7 billion were issued with at least two dealer underwriters
and in 139 transactions.

FANNIE MA E C A L L A B L E D E B T I N C LU D E D
IN BOND IN D I C ES
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, such
as those published by Citigroup, Barclays Capital, Bank of America Merrill Lynch, and
others. This is of particular benefit to those investors who determine their allocations to
various fixed-income asset classes in their portfolios based on the composition of an
index.

6 Fannie Mae Callable Debt – Reverse Inquiry Process

 Y i e l d C a l c u l a ti o n s FOR FANN I E M AE C ALLABLES

YIELD CALC ULATION S

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 affect the final yield performance of the security.

Yield-to-maturity
The yield-to-maturity calculation assumes that the debt security is not called and the
investor holds the bond to its final maturity date. The yield is calculated from the cash
flow at maturity and the periodic interest payments generated by the bond (reinvested
at a rate equal to the bond’s 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
The yield-to-call calculation assumes that the bond is called on the next eligible call date.
The yield is calculated from the cash flows of the coupon payments plus the cash flow 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 first call date (American-style
call feature). Because of the uncertainty of the call date, the yield-to-worst method was
developed. To 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. The 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.

Yield Calculations For Fannie Mae Callables 7

 PRICING FR A M E W O R K — O P T I O N - A D JUS T E D S P R E A D
(OA S) ANAL YS I S
Callable debt is usually priced and evaluated using an OAS framework similar to that
used for other option-embedded securities with cash flows 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. The OAS of a callable debt security is expressed as a spread over a noncallable
yield curve such as Fannie Mae’s noncallable Benchmark Notes® yield curve, the
Treasury yield curve, or the interest rate swaps curve. The 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 fixed-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 fixed-income
securities in analyzing investment decisions and relative value.
To calculate an OAS that most accurately captures the value of a callable debt
security, investors must incorporate their views with respect to future interest rate
volatility. Volatility represents the amount of interest rate fluctuation that is expected
over a given period of time. The expectation of future rate volatility may be influenced,
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 offers an easy and
effective method for calculating the OAS of a specific 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. The price or volatility can be calculated instead of the
OAS just as easily by plugging in the remaining two parameters and changing the
“Calculate” 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. These values are
quickly accessible and easy to interpret, with no assumption on prepayments or other
models for cash flows.

8 Yield Calculations For Fannie Mae Callables

 BLOOMBERG AOA S SCREEN F O R C A L L A B L E
MEDIUM-TERM NOTE S
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. The SIFMA guidelines incorporate skew into the volatility assumption and
recommend the use of the Black Scholes model as the OAS-to-price calculation
convention. The volatility skew adjustment corrects the value of those options that are
not at-the-money. Bloomberg’s 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.
The guidelines recommend the use of a “single credit issuer specific” 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
Mae’s noncallable Benchmark Securities constant maturity yield curve should be used.
The 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 a
coupon date.
To 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. The
security’s CUSIP may be used to bring the security into AOAS for analysis by typing
the Fannie Mae CUSIP number <CORP> AOAS <GO>. Please see Figure 2.

Yield Calculations For Fannie Mae Callables 9

 Details of each variable are provided below:
The Constant Maturity Yield Curve: The default constant maturity yield curve in
AOAS for Fannie Mae’s callable debt is Fannie Mae’s 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. The maturities defining 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. The entire
Benchmark Securities yield curve is fed to Bloomberg’s 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.
The yields provided on Bloomberg’s AOAS screen are populated by using the
average bid-side yields from contributing broker-dealers for Fannie Mae Benchmark
Notes. These yields are then designated to corresponding maturity points on Fannie
Mae’s 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. The underlying securities that make up the
constant maturity yield curve may be viewed in Bloomberg by typing AGPX <GO>.
The column labeled “Adjust” shows the constant maturity adjustment spreads. The
adjustment spreads are calculated by subtracting the constant maturity yield from the
actual yield for the same maturity point. The 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 Treasury curve by substituting these curves for the Benchmark
Securities default yield curve.

At-the-money Volatility: 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 firm Tullett & Prebon. The Tullett & Prebon swaption
volatilities are found in Bloomberg by typing TTSV <GO> 1 <GO> 2 <GO>, for
United States Dollar Swaption Volatilities or on the Reuter’s iCap page 19902. The
Tullett & 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 Yield Calculations For Fannie Mae Callables

 Skew Adjusted Volatility: The at-the-money volatility input in the AOAS model is
adjusted for skew resulting in a Skew Adjusted Volatility that more accurately reflects
current market conditions. The at-the-money volatility input in AOAS is adjusted
according to a normalized adjustment factor developed by Blyth and Uglum of Morgan
Stanley. The Skew Adjusted Volatility figure that is displayed in AOAS cannot be
overridden but may be turned off as indicated by “Use Skew Adj Vol” field. 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 different calculated
skew adjusted volatility.

Forward Strike: The 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. The 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. The Forward Strike rate that is displayed in AOAS is not a variable that can
be overridden.

Settlement Date: The 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 the
settlement date. For outstanding issues or reopenings, the default settlement date in
Bloomberg will need to be verified by the investor. The SIFMA guidelines recommend
that the settlement date is not to be greater than three days.

OAS and Price: The 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 specific 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. The 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.

Yield Calculations For Fannie Mae Callables 11

A n a l y z i n g th e c o mp o n e n t s o f c a l l a b l e d e b t

By analyzing its components, investors are able to assess the value of callable debt.
To 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 five-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 callable’s coupon (“5-year bullet
component”) and the simultaneous sale of an option to call a 3-year bullet two years
from issue date (“call option component”). Note that the option is being sold on a
forward bond. The investor has sold Fannie Mae an option to redeem a three-year
bond two years from now. The value of the callable is the difference in the value
between these two components:

Price5nc2 callable = Price5-year bullet – PriceCall option

KEY POINT S O N T H E Y I E L D C UR V E
The value of the 5-year bullet component depends on the Fannie Mae 5-year bullet
yield. The 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”). The value of the 5/2 forward is in turn derived from the yields of a
5-year bullet and a 2-year bullet.
This analysis of the key points on the yield curve can also be used for callable debt
with an American-style call feature. The 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. Thus, 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.

12 Analyzing the Components of Callable Debt

 D URATION AND CONVEXITY C H A R A C T E R IS T I C S
The effective duration of a callable debt security falls between the effective 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 fixed-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- Fannie Mae
hood of the bond being called. This characteristic of a callable debt security is known
as negative convexity. These negative convexity characteristics are also found in most
also offers
mortgage securities and some types of asset-backed securities that have embedded options. a diverse
Fannie Mae typically issues callable debt securities with various effective durations and
convexities. Fannie Mae also offers a diverse variety of structures in terms of maturities, variety of
call lockouts, and resulting durations and convexities to investors. Figure 3 illustrates
structures in
the convexity and duration profiles for several of Fannie Mae’s most commonly issued
European-style callable debt structures. terms of
maturities,
Price/Yield Relationship for a Callable Debt Security call lockouts,
and a Noncallable Debt Security
and resulting
Price durations and
Negative Convexity Segment convexities to
of a Callable Debt Security
investors.
100
Positive Convexity of a
Noncallable Debt Security

Yield

Analyzing the Components of Callable Debt 13

 IMPACT OF N E G A T I V E C O N V E X I T Y O N
FANNIE MA E C A L L A B L ES
Convexity is a feature of fixed-income securities that has a direct impact on a security’s
performance and is useful for comparing bonds. If two bonds offer the same duration
and yield but one exhibits greater convexity, changes in interest rates will affect each
bond differently. The price of a bond with negative convexity is less affected 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 final 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 option’s 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. The 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. Therefore, 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.
The 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 affects the convexity profile 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 Mae’s reverse inquiry process.

14 Analyzing the Components of Callable Debt

 IMPACT OF INTERE ST RATE V O L A T I L I T Y O N
FANNIE MAE CALLABLE S
Interest rate volatility is a market variable that has a significant 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.

IMPACT OF YIELD C URVE CH A N G ES A N D R E SH A P I N GS

ON FANNIE MAE CALLABLE S
The 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. The returns
of callable debt in a variety of hypothetical future curve shift scenarios (e.g., parallel,
flattening, and steepening) are described below. The key points on the yield curve that
affect callable debt securities are those corresponding to a security’s call and maturity
dates. For instance, the Fannie Mae 5nc2 callable debt security would be affected
most significantly by 5-year and 2-year yields. The investor could obtain from some
combination of 5-year and 2-year bullets an average effective 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. This position is often referred to as a “synthetic barbell.”

Analyzing the Components of Callable Debt 15

 Impact of the shape of the initial yield curve on new issue pricing
The nominal spread of a 5nc2 callable debt security over the 5-year U.S. Treasury 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. The 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 flatter 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 flat yield curves when the
call option is more valuable and lower spreads in steep yield curves when the call
option is less valuable.

Impact of various changes in yield curve on total returns

Interest rates and the yield curve can be expected to change over time through
parallel, flattening, and steepening shifts as well as other more complex types of
yield curve changes.

16 Analyzing the Components of Callable Debt

 Impact of yield curve changes on the performance of premium
and discount callables
A callable debt security’s 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 Mae’s 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. The 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
final maturity. These 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.

Analyzing the Components of Callable Debt 17

W H Y I N V ES T ORS BU Y C ALLABLE DEB T

Investors buy callable debt for several different, though related, reasons. Most often, the
goal is to enhance yield or returns in a high credit quality security by taking a specific
view on future interest rates or volatility.

Callable debt securities enable investors to sell interest rate options if they
cannot participate in OTC derivatives. Many investors are not able to participate
in the OTC 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. The variety of structures that
Fannie Mae issues make it possible for these investors to use callables for this purpose.

Callable debt securities generally have historically provided higher

yields than noncallable debt securities maturing on either the call date
or the maturity date. The incremental spread offered 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.

Investors buy callables to take advantage of high OAS levels. 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. The OAS of a callable debt security is expressed as a spread over a noncallable
yield curve such as Fannie Mae’s noncallable Benchmark Notes yield curve, the Treasury
yield curve, or the interest rate swaps curve. Investors gain from the alternative OAS
levels—relative to Fannie Mae noncallable securities or other corporate securities.

Investors can have exposure to the volatility of callables. When implied

volatility reaches historically high levels, investors may invest in agency callables if they
expect a reduction in implied volatility levels.

The call option on callable debt is much easier to analyze than the
prepayment behavior of mortgage-related securities. Fannie Mae’s
economic decision to call its securities is an efficient 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 final
maturity date of a callable debt security, there is no extension risk with callable debt.

18 Why Investors Buy Callable Debt

 For mortgage securities, investors must evaluate much more complicated and uncertain
call decisions requiring prepayment forecasts, many of which differ substantially among
investors even for mortgage loans of similar characteristics. These prepayment models
usually include a host of economic as well as noneconomic factors, and have historically
differed substantially from actual prepayment experience. Therefore, many investors
have found the more predictable nature of the call decision along with the structural
benefits and attractive spreads of Fannie Mae callable debt to be an appealing alterna-
tive to mortgage related securities.

Fannie Mae callable debt has historically provided attractive yields in

both steepening and flattening yield curve environments. In a rising yield
curve scenario, investors may choose to buy callables to outperform noncallable
securities of the same maturity. This 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.

Indexed investors purchase agency bullet and callable debt to match

the share of these securities in major fixed-income indices. Agency debt
is a sizable component of the major fixed-income indices. Many indexed investors
include callable agency debt in their portfolios to potentially match or outperform
their benchmark fixed-income index.

Fannie Mae has the flexibility to structure callable debt with coupon
payments to meet investors’ specific needs. 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 offers the
greatest diversity of agency callable debt in terms of maturity dates, lockout periods,
call features and interest payment dates.

Why Investors Buy Callable Debt 19

Call Process

As discussed, the callable debt redemption policy for Fannie Mae callable debt typically
has one of four call features:

European—the issue can be called on only one, pre-determined date.

Bermudan—the issue is usually callable only on a pre-determined schedule of dates.
American—the issue can be called on the initial call date or any time thereafter
until maturity.
Canary—the 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.

Fannie Mae’s 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
callable generally calls its securities issues in whole. Fannie Mae’s callable redemption policy is
redemption transparent and relatively easy to understand. It is in the company’s interest that
investors of Fannie Mae’s callable debt clearly understand why and how Fannie Mae
policy is callable debt is redeemed.
Fannie Mae’s economic decision to call its securities is an efficient and uniform call
transparent
decision based on the level of interest rates.
and relatively For instance, in an environment of falling interest rates, callable securities that have
passed their lockout period are more likely to have the call option exercised. Below is
easy to an example of the process Fannie Mae uses to determine whether or not to call a debt
understand. 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.
The yield for this security is calculated using option-adjusted spread models. The
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. This 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.

20 Call Process
 Callable Debt Securities Called Comparable Fannie Mae Debt
Call Style CUSIP Settle Amount Coupon Maturity Call Date Structure Tsy Spread Structure Yield
Date Called Date (bps)

European 3136FJ4N8 2/18/10 $100M 3.10% 8/18/15 8/18/10 5.5nc0.5 UST5 +28 5-year bullet 1.88%

Bermudan 3136FJ2Y6 2/18/10 $100M 3.05% 2/18/15 8/18/10 5nc0.5 UST5 +46 4.5nc0.25 Bermudan 2.06%

American 3136FMTE4 5/18/10 $100M 5.00% 5/18/20 8/18/10 10nc0.25 UST10 +116 9.75nc1-day American 4.09%

As stated earlier, Fannie Mae generally exercises the call option strictly on economic
grounds. 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 differs in maturity or call lockout period. Such
a difference between the new and old issues may be dictated by Fannie Mae’s 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. The time between when notice of a call
is given and when redemption of principal occurs is 10 calendar days.
It is Fannie Mae’s general practice to redeem principal on a business day (as defined
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 fixed for the
redemption. If payment is delayed because the date fixed 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 differ from
the above information.

Call Process 21
 Fannie Mae’ s W eb Site
Fannie Mae provides numerous tools and information resources for callable debt
investors on its web site. The company’s 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 Offering Circular or
Pricing Supplements. Fannie Mae’s web site also provides two reports, that are updated
daily, which detail the company’s callable debt securities issued and callable debt
securities outstanding.

Call Monitor
The Call Monitor allows investors to retrieve information on recently called securities
or to view currently callable securities. The Call Monitor allows market participants to
examine Fannie Mae’s 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.

Universal Debt Facility Offering Circular

The Offering Circular for Fannie Mae’s Universal Debt Facility outlines the general
terms of Fannie Mae debt securities. The Offering 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.
The Offering Circular is located on the Fannie Mae web site under Debt Securities =>
Debt Tools and Resources => Fannie Mae’s Universal Debt Facility.

22 Call Process
 Pricing Supplements
In addition to the Universal Debt Facility Offering Circular, debt investors should
also refer to pricing supplements for specific 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
specifications are included in the pricing supplements. The supplements also provide
identification 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 Tools and
Resources => Document Search. Agency market participants can locate specific pricing
supplements by CUSIP number.

Call Process 23
Conclusion

F
annie Mae offers 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 specifically 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 benefit from a specific
view of how the yield curve shape may change in the future. For instance, investors who
believe that the yield curve may flatten 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. The company is
committed 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.

24 Conclusion
Glossary

American-Style Call Feature: The call option may be exercised on any business day
after an initial lockout period. This type of call feature is also referred to as a continu-
ous call.

AOAS (Agency Option-Adjusted Spread): 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
Treasury or interest rate swaps yield curves.

Bermudan-Style Call Feature: The call option may be exercised semiannually on

the coupon payment dates after an initial lockout period. This type of call feature is
sometimes referred to as a discrete call.

Callable Debt: 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
specified date. Fannie Mae callable debt securities are always redeemed at par.

Call Feature: The type of call option embedded in a callable security (i.e., American,
Bermudan, Canary or European).

Call Option: An option granting the holder the right to buy the underlying asset on
(or before) a specified date at a specified (strike) price.

Call Risk: The risk to an investor that a given callable debt security will be redeemed
prior to its final maturity date, thus affecting expected cash flows and consequently
the yield on the security.

Canary-Style Call Feature: A call feature that combines a Bermudan-style call

option and a European-style call option.

Convexity: A volatility measure for bonds used in conjunction with modified

duration in order to measure how the bond’s price will change as interest rates change.
It is equal to the negative of the second derivative of the bond’s price relative to its
yield, divided by its price. For example, since a noncallable bond’s duration usually
increases as interest rates decrease, its convexity is positive.

25 Glossary
 Credit Risk: The possibility that the issuer or another party may have its credit rating
downgraded by a rating agency; may experience changes in the market’s perception of
its creditworthiness; or may default on its financial obligations to the investor.

Duration: The weighted average maturity of the present values of the security’s
cash flows. It is used as a measure of the sensitivity of the value of a security to changes
in interest rates. The greater the duration of a security, the greater its percentage
price volatility.

European-Style Call Feature: The call option may be exercised on a single date at
the conclusion of the initial lockout period.

Historic Volatility (Realized Volatility): A statistical measure of a security’s past

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

Implied Volatility: A measure of a security’s expected volatility as reflected by the

market price of the traded options on that security. The 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.

Interest Rate Risk: The 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 fixed-income securities. In a rising interest rate environment, bond prices
will decrease and in a declining interest rate environment, bond prices will increase.

Lockout Period: 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: The date on which the life of a financial instrument ends through
cash or physical settlement or expiration with no value.

Glossary 26
 Option: The right to buy or sell an asset at a specified price on, before, or after a
specified date.

Option-Adjusted Spread (OAS): A reference tool for comparing alternative

debt securities that contain embedded options. OAS refers to the yield premium over
comparable U.S. Treasury securities that a callable debt security would have if it were
noncallable—that is, if the value of the embedded option in the callable debt security
were removed from the value of the debt security.

Repo (Repurchase Agreement): 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.

Reverse Inquiry: 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 specific security issuance that will meet the investor’s needs.

Spread: Typically, in the context of pricing debt securities, the difference in

percentage or basis points between the yield of a non-U.S. Treasury debt security
being priced and the yield of a comparable U.S. Treasury security. Also refers generally
to the difference in yields or coupons between any two debt securities. Usually noted
in basis points.

Volatility: The 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.

Yield: The 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.

Yield 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
 Yield-to-Call: The 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.

Yield-to-Maturity: The internal rate of return on a callable bond or a fixed rate We deal in one
security if the bond was held until the maturity date.
asset type —
Yield-to-Worst: The lowest of all yield-to-calls or the yield-to-maturity. residential
mortgages — and
manage two types
of risk on that
asset — interest
rate and credit
risk.

Glossary 28
 figure 1.

Fannie Mae is focused on the issuance of callable MTNs that are $250 million
or larger issue sizes with multiple dealer underwriters*.

To t al Issu a n c e n um b e r o f T r an s a cti on s

80 160

$69.7 139
70 140

60 120

Number of Transactions
$49.5
50 100
$ in billions

40 80 75

$29.8
30 60 56
$24.7
46

20 40

10 20

0 0
2007 2008 2009 2010 2007 2008 2009 2010

*Callable MTNs with at least two dealer underwriters As of December 31, 2010

29 Figures
figure 2.

Bloomberg AOAS Screen – Fannie Mae 4NC1 European-style Callable Note

Evaluated Relative to the Noncallable Benchmark Curve

Resulting Resulting Up-to-date relevant mid-market European swaption

dollar price OAS volatility imported from Tullett Prebon

The noncallable Bench-

mark Securities yield
curve and associated
constant maturity yield
adjustment spreads are
Fannie Mae Benchmark
Securities yield curve
provided by Bloomberg
Agency Composite
AGPX spreads.

This exhibit is the SIFMA pricing model as it appears on Bloomberg using Fannie Mae’s recently issued
1.200% 4 noncall 1-year European-style callable note due November 3, 2014.

30 Figures
 figure 3.

Duration and convexity profiles for the most common

European-style callable debt structures.

0
5NC3 7NC4 15NC5
10NC4
-0.3
7NC3
2NC1 5NC2
10NC3
-0.6
3NC1 7NC2
Co n v e xity

-0.9

5NC1
10NC2
-1.2

-1.5 7NC1

-1.8
0 2 4 6 8 10 12 14

D u r ati o n

Source: Fannie Mae

As of December 31, 2010

31 Figures
DISCLAIME R
Fannie Mae securities are more fully described in applicable offering circular, prospec-
tuses, or supplements thereto (such applicable offering circular, prospectuses and
supplements, the “Offering Documentation”), which discuss certain investment risks
and contain a more complete description of such securities. All statements made herein
are qualified in their entirety by reference to the Offering Documentation. An offering
only may be made through delivery of the Offering Documentation. Investors consid-
ering purchasing a Fannie Mae security should consult their own financial 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 investor’s particular circum-
stances. The 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.
Our Business Is The 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
affordable rental housing for all Americans.
Because having a safe place to call home
strengthens families, communities and
our nation as a whole.
3900 Wisconsin Avenue, NW
Washington, DC 20016-2892
http://www.fanniemae.com
www.fanniemae.com
©2011, Fannie Mae