Is the secular bond bull market over? A primer on interest rate risk, Part 4

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Interest rate risk and mortgage backed securities

Mortgage backed securities have different interest rate risk than conventional Treasuries and corporate bonds. This is because of prepayment risk. When interest rates fall, borrowers will typically refinance their mortgages. To an investor, they will get their pro-rate allocation of principal early. They will not get the new loan. They simply get their money back early. This dynamic changes the way mortgage backed securities behave in response to interest rate changes.

Even though a mortgage backed security is full of 30-year fixed rate mortgages, the duration of that mortgage backed security is not going to be 30 years, or even close to it. Mortgage loans are generally amortizing loans, which means the investor gets back some of their principal in every mortgage payment. Treasuries and corporate bullet bonds do not do that. They pay interest only until the bond matures and then pay the principal back all at once. As a general rule, mortgage backed securities have durations under 10 years.

The wonderful world of changing duration

Treasuries have a duration that is relatively easy to calculate. Once the duration is calculated, an investor can predict at what price the bond will trade with relative ease. Indeed, investors who hedge interest rate in corporate bonds will use Treasuries because they behave in a very predictable manner. Mortgage backed securities do not have a duration that is easy to calculate; prepayment risk is the reason. If rate fall, the U.S. government cannot decide to pay you early. A corporate bond may or may not have a call schedule, but if the bond is non-callable, then the corporation cannot pay you back and borrow money at a lower rate until your bond matures or is callable.

This means that when you buy a mortgage backed security, you don’t know exactly when you will be paid back. And if you cannot tell when you will be paid, you cannot calculate a duration. This means that your exact interest rate risk is a moving target. How do investors predict prepayments and duration? Generally with a model, which is proprietary and will differ from firm to firm.

Is the secular bond bull market over? A primer on interest rate risk Part 5