Q19 from Reading 29 in CFAi states that on Mortgage Passthrough Securities, low coupon isses exhibit less negative convexity than higher coupon issues and will outperform during falling interest rate periods. Can someone elaborate on why this is? My thinking is that its because lower coupon issues have less prepayment risk due to less refinancing but not completely confident as to that being why.
you stated the same…you are less likely to refinance if your interest rate that you financed your home on is low i.e. your coupon is low. vice versa, if your interest rate is high, you are more likely to refinance when interest rates are low.
More negative convexity would mean a price cap that will be extremely low (which is bad for the investor). High negative convexity on the other hand means a higher price cap (good for the investor). Keep in mind, the best is not to have the price cap at all. So low coupon-paying securities, having less negative convexity, will outperform high coupon-paying securities at lower yields
You have the right logic along with BTON04’s. The extreme case to make this clearer is to think of a zero coupon bonds. If interest rate falls, what is your incentive to refinance? the answer is none, because you dont pay any coupons to begin with.
Is it always the case that if underlying mortgages of a MBS have rather low rates then the MBS (all tranches) will have a low coupon rate?
revisor Wrote: ------------------------------------------------------- > Is it always the case that if underlying mortgages > of a MBS have rather low rates then the MBS (all > tranches) will have a low coupon rate? Why would you structure an MBS with higher rates than the underlying mortgages?
There could be different tranches with higher and lower coupons than the average underlying rate. Am I wrong?
revisor Wrote: ------------------------------------------------------- > There could be different tranches with higher and > lower coupons than the average underlying rate. Am > I wrong? You’re talking about CMOs, which are different than traditional MBS pass through securities. This is from L2.
The answer in book doesn’t tell why the lower-coupon MBS exhibits less negative convexity. The above analysis of less prepayment risk and larger duration makes more sense to me.
The MBS will be positively convex until a certain point, which is most likely the rate at which most of the mortgages were originated at. If rates go below this point, the MBS will exhibit negative convexity. Rates can only go to 0, so the there will be a greater area of negative convexity with an MBS thats at a higher rate.