The 4th bullet on page 186 of the Fixed Income curriculum reading states: “Because of the negative convexity characteristics of a mortgage securtity investors consider mortgages to be market-directional investments that should be avoided when one expects interest rates to decline”. There is a nice illustration of convexity on page 165.
I understand that b/c of negative convexity the MBS will not rise as much as a treasury of the same maturity, and that the MBS will have pre-payments. However, why should MBS be *avoided* when one expects rates to decline? MBS (and fixed-income generally) would also be avoided when one expects rates to rise. So why does this avoidance turn on the convexity property?
Fixed income outperforms as rates decline ( just look at performance of bonds in last 3 years ) Mortgage negative convexity causes their value to rise less than treasuries for instance which don’t suffer from negative convexity. If you expect rates to decline , mortgage sector should be avoided. If you expect rates to rise , treasuries should be avoided and mortgage sector becomes attractive. Its a question of expectations.
“However, why should MBS be *avoided* when one expects rates to decline?” what you need to remember is interest AND principal payments are paid monthly to investors whereas bullets only pay coupons (with a single large principal payment at maturity). lower interest rates generally increase prepayments for mbs, thus, investors are now reinvesting larger cashflows in a low rate environment.