FrameworkTechniqueMacro and ratesCreditMarkets
Mortgage bonds shorten exactly when you least want them to
Mortgage-Backed Securities · 2022
The idea
Agency mortgage borrowers can repay at par without penalty. When rates fall they refinance, so the bond's cash flows come back early and its duration falls, capping the price gain that a normal bond would enjoy. When rates rise, nobody refinances and the bond lengthens, so it loses more. This negative convexity is one of the risks for which MBS investors demand a spread over Treasuries, and the New York Fed survey puts that option-adjusted spread at about 50 basis points on average since 2000, spiking in 2008 and turning negative during the later QE rounds when the Fed was the marginal buyer.
A prepayable bond gets shorter when rates fall and longer when they rise; the spread you are paid is for that asymmetry.
When it works
Fixed income, securitised products and mortgage finance interviews, and any question about why mortgage rates move with MBS rather than the policy rate.
When it may fail
The survey is about agency MBS with a government guarantee; non-agency and commercial mortgage bonds carry credit risk on top, and the convexity story is only part of their pricing.
How to use it
Asked what negative convexity is, draw the price-yield curve of a Treasury and then flatten the top of it. Then say who bears the refinancing option and what spread they are paid for it.
Where it came from
Research Mortgage-Backed Securities · Andreas Fuster, David O. Lucca and James Vickery, Federal Reserve Bank of New York (Staff Reports)
What the source says. Agency borrowers can repay at par without penalty, so prepayments rise and MBS duration falls when rates decline, capping price gains; the option-adjusted spread averaged about 50 basis points since 2000 and spiked to about 150 in autumn 2008.
Connected ideas
Says something similar
A yield is expected short rates plus a term premium, and the premium is modelled, not seenTerm premium is an estimate from a model; say which model, and treat the level as less certain than the direction.
Concepts
Put it to work on L3VLUP
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