MBS- Cash flow yield and prepayments

CFA Level II
#1

Scenerio: Higher prepayments speed

+ will increase yield if trading at a discount ** i dont understand**

my logic is:

a) low interest rates, higher prepayment, receiving faster cash flows in a lower interest rate enviroment, so a buyer would want to be compensated and demand a higher yield?

+ will decrease yield if trading at a premium ** i dont understand**

my logic: its trading at a premium because the coupon is higher than the current yield. low interest rates, higher prepayment, receiving faster cash flows in a lower interest rate enviroment, so a buyer would want to be compensated and demand a higher yield? WHEN IS IT DECREASE YIELD FOR TRADING?

#2

Think of the extreme: you get 100% prepayment.

  • If it were trading at a discount, its value just jumped up to par; yield skyrocketed.
  • If it were trading at a premium, its value just fell up to par; yield plummeted.
#3

This where I am scrambleling:

Is the yield on the par bond need to go up to par…would you want to decrease the discount rate to make the price go up from 92 to 100?

with a premium …wouldn’t you want to increase the yield to discount it back to 100?

#4

its hard to relate these concepts for me at least.

I understand if a bond is trading a a discount and it gets prepayments faster but that’s not a good thing. do to the low interest rate environment.

#5

Can you help me solidify my logic here:

Scenerio #1: hi gher prepayments speed for bond trading at discount

· Will increase yield if MBS is trading at a discount (gaining faster)

· My logic: we are receiving faster prepayments due to low interest rates, we reinvest a lower yields, and the price will approach par would we have to decrease the discount rate to increase the price from 92 to 100?

Scenerio #2: hi gher prepayments speed for bond trading at Premium

· Will decreae yield if MBS is trading at a premium (writes down losses faster)

· My logic: we are receiving faster prepayments due to low interest rates, we reinvest a lower yields, and the price will move down to par. Wouldn’t we have to increase the discount rate to decrease the price from 105 to 100?

Think of the extreme: you get 100% prepayment.

· If it were trading at a discount, its value just jumped up to par; yield skyrocketed. (me: Ok…to get 92 to 100 we would decrease the discount)

· If it were trading at a premium, its value just fell up to par; yield plummeted. (Me: Ok to get 105 to 100 we would want to increase the discount)

Can you help me spot the error in my logic? Is there a more straight forward way of thinking about this?

#6

S2000magician where you at?

#7

I was tutoring a Level III candidate, then teaching a 3-hour Level II class (Corporate Finance) at PIMCO.

I’m sorry if I’m not responding quickly enough. This is only one of the things I do during the day.

#8

S2000magician where you at?

#9

You just got paid 100% of the principal; there is no discount as the payment was today. What is your annual yield if you buy at 92 and sell at 100 5 minutes later?

You just got paid 100% of the principal; there is no discount as the payment was today. What is your annual yield if you buy at 105 and sell at 100 5 minutes later?

#10

s2000magician!

Thank you so much for all your help man!