I think this has been discussed before but I can’t find the thread… Why do PO strips exhibit negative convexity at low rates? At low rates prepayments would be accelerating and price(value) of the PO is increasing. Does it have to due with refi-burnout?
PO strips are worth more at low rates —> hence negative convexity. When rates are lower, there will be more prepayments. With more prepayments you have more principle being paid off. Since your a PO bond, you only recieve principle so a bond that said you would recieve the principle in 25 years has been reduced to 5 years. In 5 years yo will get what you were supposed to get in 25 years. This will lead to a higher yield on your PO. Hope that clears t up.
deep2002 Wrote: ------------------------------------------------------- > PO strips are worth more at low rates —> hence > negative convexity. Non-callable bonds are worth more at low rates and don’t exhibit negative convexity. > > When rates are lower, there will be more > prepayments. With more prepayments you have more > principle being paid off. Since your a PO bond, > you only recieve principle so a bond that said you > would recieve the principle in 25 years has been > reduced to 5 years. In 5 years yo will get what > you were supposed to get in 25 years. This will > lead to a higher yield on your PO. > > Hope that clears t up. I agree with what you wrote about the prepayments, but why at really low rates does the negative convexity come in?
I can understand why the IO strips start to lose value at really high interest rates. I assume that is due to the increased discount of the cash flows canceling out the interest payments…but I don’t get the PO negative convexity.
Then I would say it has to do with the prepayment burnout. That’s as much as I know, don’t have a good explanation for it.
Because there are many non-interest rate sensitive borrowers who won’t refinance no matter what interest rates do. A few years ago they retired GNMA pool #1 with 3 people making their final mortgage payment. They had 30 years worth of opportunities to move or refinance but they just kept paying. One of the news shows wanted to interview them and talk about what a great thing mortgage securitization was for the American dream. All refused to be interviewed.
They sound smart.
I would asssume that is because of the burnout