One market observer said that PO’s were like “super” zeros - they had more price volatility than a comparable set of Treasury STRIPs. Is this true? Why or why not?
I cannot find anything to substantiate this claim. However, wouldn't the price volatility depend on the maturity and consequently the duration of any MBS? Obviously with prepayment risk you would have to have a longer mortgage maturity date than standard Treasury STRIP, whose effective duration IS its maturity.
A little clarity on this topic would be appreciated.
I'm sure there are people on this forum who can give a more knowledgeable answer here, but offhand I would assume that the increased price volatility associated with POs is a product of their embedded prepayment risk. Similar to other bonds that contain principal repayment options, it makes sense that POs would be relatively more responsive to changes in interest rates than would option-free bonds such as STRIPS.
IO's also have prepayment risk.
"However, wouldn't the price volatility depend on the maturity and consequently the duration of any MBS?"
Of course, but for a comparable security why is the PO's duration different? first tell me what the duration of an IO is, and we can go from there.
Unless you mean you want me to describe to you a specific issuance.
When interest rates decline the value of the PO will increase more than a similar Treasury STRIP due to the speed up in prepayment rates. Both the Treasury and the PO are positively affected when market rates decline due to the lighter discounting. In addition, the PO holder is getting principal quicker whereas the maturity of the Treasury Strip does not change. The quicker the PO investor receives the payments, the higher the present value even if the discount rate didn’t decline to help.
If prepayments are not sensitive to interest rates, the stream of nominal interest payments will not be sensitive to market rates. In this case, the market rate will affect only the present value of the stream of payments and the IO would behave like normal fixed income instrument whose value varies inversely with market interest rates. In contrast, if prepayments speed up when rates decline, the nominal interest payments will be smaller. Here the decline of nominal interest payments may dominate the positive effect of using a lower discount rate.
In general, the coupon of the underlying MBS relative to the current market rate on those MBS is the key ingredient in determining whether an IO is “normal” or “perverse”.
Of course the duration of an IO is necessary to think about b/c you are asking the duration of just a PO. IO+PO together = normal mortgage bond, right? So if you know what the duration of an IO is (it's negative) then you know that PO's must have higher duration than combined bonds.
Same sort of argument for inverse floaters.
and as to this "If prepayments are not sensitive to interest rates, " when are prepayments ever insenstive to rate level?
So Jimbo - this is probably a very noob-sounding question for you (I'm generally pretty knowledgable on the PE/IB/Consulting forums here, but really don't know much about trading), but what do you mean when you say that the duration of an IO is negative? I understand the basic math behind why the duration of an IO component for an MBS (or any asset-backed security, for that matter) would be relatively lower than for the PO portion, but don't understand how the duration of an IO could actually be negative.
"but what do you mean when you say that the duration of an IO is negative?"
i mean it is negative...so when rates rise, the price of an IO goes up, not down.
think about rates up, prepayment down, coupon stream extends, value of IO up.
I wasn't referring to the effects of interest rates, but rather to the concept of duration itself.
I'm guessing that we're speaking in different terms here - I have always understood duration as something expressed in units of time, hence my confusion with your reference to "negative" duration.
"I'm guessing that we're speaking in different terms here - I have always understood duration as something expressed in units of time, hence my confusion with your reference to "negative" duration."
when i say duration i mean change in price for a given change in rate. call it negative dv01 if you prefer.
Gotcha, thanks for clarifying.
no probs...you've seen about the extent of my mortgage knowledge btw.
Yup I understand this. I guess some of these things I inherently knew but it was becoming difficult for me to properly articulate them.
So this is all fine with the theory behind it all; but I'm wondering how it actually works in practice. Given an incremental interest rate "move", with the level of liquidity in a given market, do traders jump from one income stream to another as fast as they possibly can? Will they divest their POs and jump into treasuries if they've locked in a certain (goal) profit level?
I know this is a gray area, because it is dependent on the goal of the trader & portfolio manager, but I'm trying to understand this outside of the theoretical construct we've discussed.
not sure...my product is tremendously illiquid, and the trading dynamics are quite different.
what is your product, jimbo?
funkadelic rates
Awesome. Sorry, don't mean to hijack the thread, but I love finance, math and geopolitics, and rates seem pretty interesting (not to mention I'd love trading). Think those interests cater to it well?
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