MBS: Market directional

I am confused by CFAI EOC Problem 32.3 (CFAI book 4, page 170): The problem asks to explain why a portfolio overweights MBS relative to other instruments, specifically “… my concern is with the prudence of doing so. It is well known that MBS are market-directional securities. – Question: What should the response be?” From the answer section (appendix): “There are investors who consider mortgages to be market-directional investments that should be avoided when one expecs interest rates to decline. However, when properly managed by separating mortgage valuation decisions from decisions concerning the appropriate duration of the portfolio, mortgage securities are not market-directional investments. The ability to separate the value decision from the duration decision hinges critically on proper hedging. One must offset the interest rate-driven changes in the duration of mortgage securities to prevent the portfolio drifting adversely from its target. Hedged improperly, the portfolio’s duration will be shorter than desired when interest rates decline and longer than desired when interest rates rise.” I do not understand a word of what they are saying here. 1. Why or why not would MBS be considered market-directional? 2. What do they mean by “separating mortgage valuation decisions from decisions concerning the appropriate duration of the PF”? I.e., how would you NOT include valuation decisions before duration hedging? 3. What do they mean by “proper hedging” and the “portfolio drifting adversely from its target”? 4. Why do they refer to “improperly hedging” only as shorter duration when rising and not the other way around? Thanks, OA

On their own, MBSs are market directional, since they respond to interest rates, and you can decide to have more or less of them depending on your view of interest rate changes. However, you can hedge the interest rate risk either by going long some MBSs and short others with similar qualities, or by using other hedging techniques like the two-bond hedge, which could also be a two-futures hedge. You would do this if you think that a specific MBS is undervalued and want to lock in gains from that undervaluation without taking on the interest rate risk that you’d have if you just went out and bought the the MBS and add it to the portfolio. By doing this (what they mean by “proper hedging” to eliminate interest rate risk) you can take advantage of the undervaluation (or potentially overvaluation if you are going to short) without messing up the duration of the portfolio.

Thanks. I was initially confused by the wording “market directional”, I was not sure whether that refered to - moving with interest rates (as other bonds do) - moving with the real estate market (as the underlyings relate to real estate) - move in some other direction considered “the market”

Usually market directional means that you are making some investment in anticipation of the market doing something. You could also call it speculating, but speculation often has a negative connotation that “market directional” doesn’t seem to have (since market directional somehow implies - rightly or wrongly - that you’ve done some analysis to back up your expectations). If you’re doing some kind of arbitrage, it doesn’t really matter what the market does, so that’s not market directional, but you still expect to make money (usually with something like valuations differences). “Market neutral” is sometimes considered “nondirectional,” but in practice you are often just making bets on different aspects of the market (say spreads between securities, rather than how the market as a whole will move). As you dig down in detail, it starts to get tricky to separate true non-directional from directional, but at a first approximation, it’s mostly about whether you are investing in expectation some big market characteristic to change (market as a whole goes up, interest rates change, something like that).