Can someone please explain why Mortage Backed Securities are more senstive to Yield Curve risk that Option Free Bonds? From the CFAI “The value of an option free bond with a bullet maturity payment (entire principal due at matyurity date) is senstive to changes in the level of interest rates but not as sensitive to changes in the shape of the yield curve. This is because for an option free bond whose cash flow consists of periodic coupon payments, but only one principal payment (at maturity), the change of rates along the spot rate curve will not have a significant impact on its value” Can someone elaborate on this more?
dtrynoski Wrote: ------------------------------------------------------- > Can someone please explain why Mortage Backed > Securities are more senstive to Yield Curve risk > that Option Free Bonds? > > From the CFAI “The value of an option free bond > with a bullet maturity payment (entire principal > due at matyurity date) is senstive to changes in > the level of interest rates but not as sensitive > to changes in the shape of the yield curve. This > is because for an option free bond whose cash flow > consists of periodic coupon payments, but only one > principal payment (at maturity), the change of > rates along the spot rate curve will not have a > significant impact on its value” > > Can someone elaborate on this more? First of all, “This > is because for an option free bond whose cash flow > consists of periodic coupon payments, but only one > principal payment (at maturity)” Did you mean “whose cash flows DOES NOT consists of coupon payments, but only…” If it means that, then Since it is a bullet bond, there is no worry of reinvestment (of coupons). So the rate changes will not have a significant impact on its value.
No I mean “whose cash flows consist of perioddic coupon payments” your thinking of a zero coupon bond. A bullet bond is essentially a bond not callable, putable or sinkable prior to its scheduled final maturity.
dtrynoski Wrote: ------------------------------------------------------- > No I mean “whose cash flows consist of perioddic > coupon payments” your thinking of a zero coupon > bond. A bullet bond is essentially a bond not > callable, putable or sinkable prior to its > scheduled final maturity. Option free bonds have positive convexity; while mortgage-backed securities, have negative convexity, meaning their price and yield relationship is convex rather than concave. Negative convexity creates extension risk when interest rates rise, and contraction risk when interest rates fall. Hence more sensitive.
I think it is because MBS’s cash flows include both inteterst payments and repayments of principal and MBS’s duration will be greater than that of the option-free bond with a bullet maturity payment, all else being equal. Anyone else can confirm if I am right ?
Reinvestment risk from the cash flows containing both inteterst payments and repayments of principal may be a major factor !
A couple of point and questions: #1 A zero-coupon bond is a type of bullet bond, so is a bond that pays interest on a periodic basis(that has no call/put feature or sinking fund feature). #2 all else equal a bullet bond that pays interest on a periodic basis will have a lower duration than an equivalent zero coupon bond. #3 I agree reinvestment risk is greater on MBS b/c of repayment of principal and interest, however I think the duration is higher only due to the fact that there is a call option associated with this type of investment. If there was no option to be called, then the extra repayment would actually lower its duration from an equivalent interest pmt only or zero coupon bond. the fact that this bond type could be called at lower interest rates causes the price to fluctuate further over the yeild curve due to the fact that an investor may need to reinvest proceeds at a lower interest rates. Does anyone agree with #3? this is not something I’ve read in any readings - just a postulation of my own.
Duration of MBS is LOWER that option free bond. This is because the change in price when rates fall is lower compared to an option-free bond due to higher value of the prepmt option. When rates rise, the change in price for MBS is also lower compared to option-free bond because the value of prepmt is lower and approaches zero.
Your right the net duration of the call and MBS is lower (MBS duration less the call duration flattens the curve) So the reason MBS’s are more sensitive to yield curve risk is because of the extra principle being repaid (ie. larger near term pmts) which needs to be reinvested at current rates which are generally more volatile than long term rates (esp. when referreing to yield curve risk which is a flattening or steepening of the yield curve and not a parallel shift).
Someone said duration of a MBS is longer than its maturity. Plese refer to : http://www.analystforum.com/phorums/read.php?13,1233261,1233334#msg-1233334 Can anyone confirm ?
Duration of MBS is shorter than its maturity. Take a typical 30 year fixed mortgage. Most don’t ever last that long due to prepayments to pay off loans faster and refinances when rates drop.
I think even if no refinances, duration of MBS is shorter than its maturity. Am I right ?
Yes you are right.
elcfa Wrote: ------------------------------------------------------- > http://www.analystforum.com/phorums/read.php?13,1236900 Shall it be http://www.analystforum.com/phorums/read.php?13,1233261 ?
alta168 Wrote: ------------------------------------------------------- > Shall it be > http://www.analystforum.com/phorums/read.php?13,12 > 33261 ? Yes. Thanks for the correction.