Leland Abrams serves as Chief Investment Officer for the investment manager, Wynkoop LLC. Leland is Lead Portfolio Manager of an NARMBS income-oriented fund at Catalyst Funds which utilizes Agency Mortgage IOs as a positive carry interest rate hedge. Rather than shorting treasuries and owing the coupon, owning Agency IO allows the investor to get paid monthly, earning coupon, while expressing negative duration.
- Agency mortgages are those that are explicitly or implicitly guaranteed by the government. There are three GSEs (Government Sponsored Entities); Fannie Mae, Freddie Mac, and Ginnie Mae. GSE mortgages and bonds backed by those mortgages have no credit risk, but do have interest rate risk.
- Agency mortgages exhibit negative convexity, which is the second derivative of the price / yield function with respect to interest rates. For those calculus junkies, convexity is the “rate of change of duration with respect to changes in interest rates”.
- Agency mortgages duration and re-finance/prepayment speeds tend to respond to rate moves with high degrees of predictability. When rates go higher, refinance or prepay rates slow and mortgage duration extends. When rates go lower, mortgages refinance and prepay, shortening the average life or duration.
Prepayment Speeds Behave Inversely to Interest Rates
Fannie Mae 4% mortgage pool prepayment speed (CPR) versus the Generic 10-year U.S. Treasury yield
- Included in Agency MBS mortgage bond deals are interest only bonds. These bonds are carved off the mortgage pool and only pay interest, issues at some multiple to their coupon. Since they do not receive principal, they are very sensitive to shifts in prepayment speeds. Prepayment speeds correlate to the amount of notional bonds outstanding; when the underlying mortgages pay fast, there are less bonds remaining. When the underlying mortgages do not prepay, the life of the mortgages extends out and the resulting interest cashflow becomes more valuable.
Rates Going Lower Example:
An investor buys a Fannie Mae IO with a 5% coupon, which for demonstration purposes could have traded at $20-00 (4x coupon, or 4 years’ interest payments assuming no prepay).
Rates drop and now those people can refinance with a 2.5% mortgage… they go ahead and refinance after the Fannie 5% IO was owned for 2 years … the investor received 10 cents of interest and now the bonds are gone, translating into an approximate 50% loss.
Rising Rate Scenario:
An investor buys a Fannie 2.5% IO at 4x its coupon, which would be $10-00 (4x coupon, or 4 years’ interest payments).
Rates go higher and prevailing mortgage rates increase. One would expect nobody to refinance since there is no economic incentive to pay a higher mortgage rate. If the pool of mortgages extends to its end, all 30 years, then 30 X 2.5% coupon = $75-00. One can buy bonds backed by 2.5% mortgages between $10 and $13, which could ultimately have a stream of cashflow worth nearly $75.
- Example bond and its price upside or static yield depending on prepayment speeds (CPR = conditional prepayment rate expressed as percentage of the mortgage pool prepayment annualized). This is a 2.5% Ginnie Mae IO which is 3 months old (WALA = weighted average loan age).