Mortgage backed securities (MBS) have sold off sharply over the past month as fixed income markets face the new reality of rising rates.
Source: Mortgage News Daily
But unlike most other fixed income securities, MBS duration tends to increase with yield. That’s because higher MBS yields typically mean higher mortgage rates and lower mortgage refinancing activity (which we have already seen). Pools of mortgages backing many MBS, particularly loans with lower coupon, will experience slower prepayment speeds going forward. Slower refinancing extends the effective duration of the bonds (illustration below).
If you have a 30-year mortgage at 3.6%, it is now less likely you will refinance any time soon (mortgage rates today are above 4%). One reason your mortgage is not treated as a full-term 30-year note is the probability that you will sell your house, thus terminating the note. There is also some probability that in the future, mortgage rates will drop below 3.6% again, providing you another opportunity to refinance. The expected average life of your 3.6% mortgage and the security that is backed by your loan has therefore been extended (from you potentially refinancing in the next six months to you selling your house in say 5 years). And if rates rise further, prepayments will slow even more. The chart below shows the prepayment speed (PSA) for just such a security over the past month as well as the expected prepayment speeds going forward. It also shows what happens if rates increase by another half a percent....MORE
