Another Look at Prepayment Risk of Mortgage-Backed Securities

Yesterday the Federal Reserve Chair Janet Yellen said at a University of Michigan event that the Fed planned to raise short-term interest rates.

“I think we have a healthy economy now … but it’s been a long time coming,” Yellen said.

Yellen said the current unemployment rate of 4.5% is “even a little bit below” what Yellen and her other colleagues at the Fed would consider “full employment.” She said inflation is “reasonably close” to the Fed’s stated goal of two percent. Read more

In a previous post, we argued that rate hikes will increase volatility through hedging of prepayment options embedded in mortgage-backed securities.

Recently, Mark Robinson presented another argument:

Analysis from SocGen published during the fourth quarter of 2016 points to a 2.6 per cent return on 10-year notes (the equivalent rate for the UK was 1.7 per cent). This reflects the general view that US equity valuations are stretched based on underlying earnings. If we accept that once investments in riskier assets such as equities are deemed relatively expensive to government-backed debt, then stocks could be subject to bigger price swings with increased frequency. Read more

This means  that when interest rate rises, equities  will appear to be expensive relative to government-backed bonds, hence they will be susceptible to selling, thus causing an increase in volatility.

Regardless of the argument, with a rising rate, one might think that it’s risky to invest in fixed-income securities.  However, Tim Mullaney  recently reported that:

Gundlach, CEO of DoubleLine Capital, is betting that the best way to play the coming rate hikes is by holding lots of mortgages

But how about prepayment risk?

“Gundlach doesn’t see prepayment risk as particularly high right now, but if prepayments spike, there’s a risk of losses for the fund.” Read more

Good investment decision sometimes seems counterintuitive.  And if this is true, then prepayment risk will not be a threat to market volatility. Let’s see how this plays out.

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