what is the reasoning behind this logic?
- assuming so, it’s because refinancing will be higher for the higher rate bonds vs the lower rate bonds, hence the difference in sensitivity.
because more CF could be wiped out with high convexity
low convexity, less CF are at risk
Think of the curve for convexity. lower convexity is closer to the standard yield/value relationship
Low coupon MBS is less likely prepaid, or the prepayment speed is slower for the low-coupon MBS.
For mbs, a low coupon issue can be thought of as selling a call option with an out the money strike. A high coupon is the opposite, it is similar to a in the money option due to the borrower having an incentive to refinance their loan if the market rate is lower. As a result the negative convexity of the option does kick in until it is near atm or itm.
in case of bond yield is high and bond issued at discounted?
I think it comes from bullet of cashflows -> high coupon -> more diverse -> more sensitive
Then it will be more complicated…
MBS are usually mortgage pass-through. High-coupon MBS are backed by MBS with higher mortgage rate. Those home owners with higher mortgage rates will most likely to refinance.
Negative convexity is caused by prepayment in MBS. Prepayment is most relevant to this question.
In an extreme case, the mortgage rate = 0, no negative convexity exists.