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Regarding MBS I understand that as rates fall people with mortgages will want to refinance and thus mortgage prepayments will increase, causing the life of the MBS to decrease and for the investor to receive their money earlier then expected. However all the articles I’ve been reading on the subject talk about how the investor will have to reinvest at a lower rate. But my question is the significance of that because the investor will already be reinvesting the cash flows at market rates since mortgage paynents are comprised of interest and principal? Is is simply the timing of the investment ending early?

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The payment of a "normal" MBS tranche don't distinguish between interest and principal - when a mortgage payment is made, the full payment goes to the tranche holders in whatever order the MBS dictates. But prepayments get them their money back sooner than expected, which could be bad if interest rates are lower.

For example, if you're holding a tranche that is scheduled to pay for 2 years (based on the interest rates at the time you purchased it) if there are no prepayments, and, because of prepayments due to interest rate declines, your tranche gets paid off today, now you have all of your money back, but can only reinvest at current interest rates

It's analogous to a bond getting called. If you hold a callable bond that pays 10% interest, but interest rates fall to 5%, that bond is likely to be called, paying you back in full. But now instead of getting 10% interest, you can only reinvest (in other bonds) at 5% interest, so the call is harmful to you.

  • @D Stanley but say those prepayments are made throughout the term of the mortgage instead of a lump sum like a refinancing. Then assuming that the investor is actively reinvesting those payments that risk should be mitigated no? – Skrrrrrtttt Aug 21 at 21:57
  • No because they are (presumably) reinvesting those prepayments at a lower interest rate (which is the assumption of why there's prepayments in the first place) – D Stanley Aug 21 at 22:12
  • But would the risk not then just be dependent on the underlying market rate, because as you said interest and principal payments are combined so there is no lump sum of principal to be reinvested at the end – Skrrrrrtttt Aug 21 at 22:17
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    Right so if the reason there are prepayments is because interest rates are lower then that's bad for the MBS holder. – D Stanley Aug 21 at 22:29

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