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Let’s take a typical recently issued Ginnie Mae 3.5% security. The loans in that security will have mortgage rates of anywhere from 3.75% to 4.25%. The various brokers will come up with their prepayment estimates, and from that decide what they think the actual maturity of the bond will be. For argument’s sake, let’s say that the estimate is seven years. This number is a forecast based on historical prepayment activities, probably a Monte Carlo simulation of interest rate movements, and a model of default probabilities based on the underlying collateral.
So, let’s say the Street forecast of seven years is more or less correct. For small changes in interest rates (say 25 basis points), the bond will behave according to the duration formulas. A drop in interest rates will increase bond prices by a predictable amount, and an increase in rates will lower the price by a predictable amount.
But what happens when rates change by a lot? Let’s say fears of a recession force rates down by 75 basis points, and the 10-year bond drops to below 1.5%. The borrowers will probably be able to refinance their homes at 3.25% to 3.5%. The MBS investor will find they are getting back their principal way faster than they expected, and their seven year duration is probably closer to four years.
Conversely, what happens if interest rates rise another 75 basis points? The only people who prepay their mortgage are those who are moving. There will be no incentive to refinance. That seven year duration may become closer to ten years. That is why mortgage backed securities are so difficult to manage.
Note that in a declining interest rate environment, duration shortens and the bond becomes less sensitive to interest rate movements. As a bond investor, you want to see a declining interest rate environment, and unfortunately, your bond delivers less and less capital gains as rates decline. Conversely, when rates increase, your bond delivers more and more capital losses as interest rates rise because duration lengthens which increases the sensitivity of the bond to interest rate movements. Nirvana for a MBS investor is low interest rate volatility – they earn a premium over Treasuries and movements are relatively predictable. This behavior is called negative convexity.
© 2013 Market Realist, Inc.