Ok guys, I tend to get confused when there’s interest rate risk and prepayment risk in the same question. Doesn’t interest rate risk cause prepayment risk? So if the question is like the one below, how should I analyze it?
How I analyzed the below question: because nonamortized debt would react to changing interest rate so much, so the prepayment wouldn’t be a big issue.
Camby is excited about a new ABS issued by a large retailer, Glendo’s. The ABS reflects a bundle of nonamortizing consumer credit accounts. As usual, Price prefers a different option, in this case a new collateralized mortgage obligation (CMO) issued by Trident Mortgage. Both securities offer similar total return potential and seem reasonably valued. Both Camby and Price believe the other analyst’s preferred securities are too risky.
Camby’s preference for Glendo’s bonds suggests he is most likely concerned about: A) credit risk. B) interest-rate risk. C) prepayment risk. Your answer: B was incorrect. The correct answer was C) prepayment risk. We have little information about the Glendo’s and Trident bonds. All we know is that the Glendo’s ABS is backed by consumer credit accounts, while the Trident securities are backed by mortgage loans. Most consumer-credit accounts are nonrevolving, meaning that during the lockout period, any prepayments will be invested in new loans. As such, the Glendo’s ABS probably has less prepayment risk than the Trident ABS. We don’t know enough about the loans to conclude anything about their credit or interest-rate risk. But the difference in prepayment risk is apparent. Camby’s preference for Glendo’s suggest he wants to avoid prepayment risk. (Study Session 13, LOS 40.b)