can someone plz explain to me how the slope of the yield curve affects prepayment risk of MBS’s. thx.
If you’re paying on a fixed-rate prepayable obligation (like a FR mortgage loan), when do you prepay? When rates drop. Not sure though what difference slope makes – the absolute level is most important.
Some theories suggest that the shape of the yield curve predicts expected future interest rates, which, if you believe it, might predict when people decide to prepay and refinance. I forget the name of the theory from L1, I think it was the “simple expectations theory”, and it was contrasted with something like the “liquidity premium theory” and the “preferred habitat theory.” I don’t remember the names, but I do remember the argument.
I would prequalify it by saying that the long end of the curve primarily determines when people will prepay.
With the yield curve sloping downwards, people expect the rates to drop and you can expect prepayment speeds to pick up, and vice versa. This is not a very strong/predictive relationship, first because forward rates are a poor predictor of future rates, and second because it really depends on where the current rates are with respect to the coupon of your MBS - if the coupon is low enough, even falling rates may not drop low enough to influence the prepayment speeds on your particular MBS.