Extension risk with IO bonds
What is extension risk in bonds?
What Is Extension Risk? Extension risk is the possibility that borrowers will defer prepayments due to market conditions.
What is contraction and extension risk?
Whereas contraction risk happens when borrowers pre-pay a loan, shortening its duration, extension risk occurs when they do the opposite—they defer loan payments, increasing the length of the loan.
What are two risks that a CMO investor faces?
Risks to CMO investors include the possibility that all payments won’t be made on time, loss of premium due to prepayments, market risk when interest rates rise, and prepayment and extensions when principal is returned earlier or later than expected.
What is the effect of changing interest rates on the shape of the IO and PO?
Declining interest rates increase PO repayment speed, lowering the discount rate and increasing the PO price. Rising interest rates cause prepayments to decelerate and increases the discount rate applied to cash flows, thus lowering the PO price.
What is the difference between a MBS and CMO?
A collateralized mortgage obligation, or CMO, is a type of MBS in which mortgages are bundled together and sold as one investment, ordered by maturity and level of risk. A mortgage-backed security, or an MBS, is a kind of asset-backed security that represents the amount of interest in a pool of mortgage loans.
Which tranche has the highest contraction risk?
tranche A
At higher levels of prepayment, the average life of tranche A falls to 1.6 years and to 7 years for tranche D. Tranche A has the highest contraction risk while tranche D has the highest extension risk. Tranches A and B provide protection against contraction risk for tranches C and D.
What is CPR mortgage?
Periodic Conditional Prepayment Rate (CPR) is the annualised percentage of a mortgage pool’s principal balance that will be paid off each period ahead of schedule.
What is prepayment risk?
Prepayment risk is essentially the risk that the mortgage-backed security buyer will receive, say, seven years of interest income at an agreed-upon rate, on top of principal repayment, instead of 10 years of such interest. Prepayment forces the buyer to reinvest the principal, often at a lower rate of return.
What does mortgage extension mean?
A mortgage extension agreement is a type of loan modification, which is structured to help struggling borrowers. The modification changes the original terms of the mortgage by extending its due date, but it’s not an automatic right of borrowers to invoke.
What is the relationship between changes in interest rates and changes in value of a principal-only PO Strip?
Investors in PO strips benefit from faster repayment speeds while also being protected from contraction risk. This means that, unlike a usual bond or traditional MBS, the PO investor will benefit from decreases in the interest rate as the loans are likely to get repaid faster.
How does prepayment risk affect the value of a principal-only tranche in a CMO?
Principal-Only (PO) Securities
Note that higher prepayment rates will result in a shorter term for the bond, thus paying the face value in a shorter term, effectively increasing its yield.
What causes the maturity risk?
The Maturity Risk Premium
The larger duration of longer-term securities means higher interest rate risk for those securities. To compensate investors for taking on more risk, the expected rates of return on longer-term securities are typically higher than rates on shorter-term securities.
Is MBS a debt or equity?
A Mortgage-backed Security (MBS) is a debt security that is collateralized by a mortgage or a collection of mortgages. An MBS is an asset-backed security that is traded on the secondary market.
Is a MBS a bond?
Mortgage-backed securities, called MBS, are bonds secured by home and other real estate loans. They are created when a number of these loans, usually with similar characteristics, are pooled together.
Are MBS guaranteed by the government?
Like Fannie Mae, Freddie Mac can issue and guarantee MBSs, but its guarantee is not backed by the government. Ginnie Mae (the Government National Mortgage Association) differs from Fannie Mae and Freddie Mac in that it operates as a government agency.
Why did mortgage-backed securities fail?
Demand for mortgages led to an asset bubble in housing. When the Federal Reserve raised the federal funds rate, it sent adjustable mortgage interest rates skyrocketing. As a result, home prices plummeted, and borrowers defaulted. Derivatives spread the risk into every corner of the globe.
Is the Fed still buying MBS?
In 2017, the Fed started letting some of its mortgage bonds expire. But then, in 2020, the pandemic happened, so the Fed went back to buying mortgage bonds.
Who owns agency MBS?
The overwhelming majority of agency MBS, 85.5 percent, is owned by domestic entities, including the Federal Reserve, whose holdings have increased during the last year.
Does MBS have credit risk?
Limited credit risk Because of their relationship with the U.S. government and U.S. Treasury, agency MBS carry limited credit risk and may offer a safe haven for investors during periods of volatility. Interest rate shocks MBS are less susceptible to unexpected interest rate shocks compared with U.S. Treasuries.
Do agency MBS have default risk?
Agency MBS are guaranteed by the GSEs that issue them, and because of that, they are considered to have very little risk of default. Consequently, their yield is generally quite low, usually only offering a small pick-up over US treasuries. Their main risk factors are interest rate risk and pre-payment risk.
Why is Fed buying MBS?
Agency MBS purchase typically refers to the Fed’s program to purchase $1.25 trillion worth of agency MBS from government-sponsored entities. The goal was to prevent the bankruptcy of the government-sponsored entities by propping up the prices of their securities.
What will happen if the Fed stops buying bonds?
As the Fed withdraws from the bond market (e.g., reduces bond demand), interest rates will rise. When the bond buying stops, the government will have to finance its spending by borrowing from the public (issue bonds), reducing the spending power of the private sector.
Who owns the most MBS?
Japan increased its agency MBS holdings from $26 billion in 2003 to $293 billion in 2019, thus becoming the largest foreign owner of agency MBS with a 27.3 percent share.