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Primer on mortgage backed securities, Part 4

ConvexityEnlarge GraphContinued from Primer on mortgage backed securities, Part 3.

Interest rate risk

Interest rate risk is probably the biggest risk to mortgage backed securities. The reason why is because the duration of an MBS is uncertain. Duration means a lot of things, but in mortgage backed securities, we are referring to the fact that you know how much principal you are going to get, but you don’t know exactly when you will get it. This makes hedging the interest rate risk difficult.

All bonds have interest rate risk. This is generally measured by duration, which is the measure of how sensitive the bond is to interest rates. If interest rates fall, bond prices rise. Conversely, if interest rates rise, bond prices fall. This is because a bond price simply represents the present value of the cash flows of the bond. Since a dollar today is worth more than a dollar tomorrow, cash flows in the future are discounted by a discount factor representing the time value of money. So if rates fall, the discount factor drops and the cash flow is worth more in present dollars.

With MBS, it is tough to measure interest rate risk because the actual maturity of the bond is an unknown. Because of prepayments, your MBS could go from 7 years to 5 years or 12 years, depending on what interest rates are doing. Because of that risk, MBS get paid more because of the additional interest rate risk they are taking. If you look at the chart above, you can see that as interest rates rise (on the x-axis), both normal bonds and mortgage backed securities fall in price.

To illustrate with an example, we pulled up the Ginnie Mae 3% June TBA. The price is 103, which translates into a yield of 2.49% at an assumed life of 7 years. Even though the security is made up of 30-year fixed rate mortgages and is officially a 30-year security, but in practice mortgages rarely get paid off in 30 years. People move, people default, which shortens the life of the pool. The current forecast for this security is that it will last about seven years. So you are getting 2.49% yield in a government-guaranteed security that has no credit risk. Conversely, the 7-year U.S. Treasury bond is trading at 1.38%.  So same expected maturity, same credit risk (zero) and the mortgage backed security yields 110 basis points higher than the corresponding Treasury. Why is this? Free money?  No, it isn’t “free money” as the Treasurer of Orange County found out. It is compensation for the extra interest rate risk and liquidity risk you are taking with a mortgage backed security.

Continue to Part 5.

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