About MBS/ABS
Interest Rates and Yields on Mortgage Securities
Yield. Mortgage securities are often priced at a higher yield than Treasury and corporate bonds of comparable maturity, but often lower than the interestrates paid on the underlying mortgage loans. This is because a portion of the interest paid by the mortgage borrower is retained by the loan servicer as a servicing fee for collecting payments from borrowers and distributing the monthly payments to investors. Furthermore, Fannie Mae and Freddie Mac collect‘guarantee fees’ as compensation for their guarantees on their agency securities. Interest rates on mortgage securities are higher than Treasury and corporate bonds to reflect the compensation for the uncertainty of their average lives as well as their higher credit risk.
As with any bond, the yield on a mortgage security depends on the purchase price in relation to the interest rate and the length of time the investor’s principal remains outstanding. Mortgage security yields are often quoted in relation to yields on Treasury securities with maturities closest to the mortgage security’s estimated average life. The estimated yield on a mortgage security reflects its estimated average life based on the assumed prepayment rates for the underlying mortgage loans. If actual prepayment rates are faster or slower than anticipated, the investor holding the mortgage security until maturity may realize a different yield. For securities purchased at a discount to face value, faster prepayment rates will increase the yield-to-maturity, while slower prepayment rates will reduce it. For securities purchased at a premium, faster prepayment rates will reduce the yield-to-maturity, while slower rates will increase it. For securities purchased at par, these effects should be lessened.
Because mortgage securities pay monthly or quarterly, as opposed to on a semiannual schedule, mortgage security investors can use their interest income much earlier than other bond investors. Therefore, mortgage securities are often discussed in terms of their bond equivalent yield, which is the actual mortgage security yield adjusted to account for its greater present value resulting from more frequent interest payments.
Interest Rates. Prevailing market interest rates affect mortgage securities in two major ways. First, as with any bond, when interest rates rise, the market price or value of most types of outstanding mortgage security tranches drops in proportion to the time remaining to the estimated maturity. Conversely, when rates fall, prices of most outstanding mortgage securities generally rise, creating the opportunity for capital appreciation if the security is sold prior to the time when the principal is fully repaid.
However, movements in market interest rates may have a greater effect on mortgage securities than on other fixed-interest obligations because interest rate movements also affect the underlying mortgage loan prepayment rates and, consequently, the mortgage security’s average life and yield. When interest rates decline, homeowners are more likely to refinance their mortgages or purchase new homes to take advantage of the lower cost of financing. Prepayment speeds therefore accelerate in a declining interest rate environment. When rates rise, new loans are less attractive and prepayment speeds slow.
If interest rates fall and prepayment speeds accelerate, mortgage security investors may find they get their principal back sooner than expected and have to reinvest it at lower interest rates (call risk). If interest rates rise and prepayment speeds are slower, investors may find their principal committed for a longer period of time, causing them to miss the opportunity to earn a higher rate of interest (extension risk). Therefore, investors should carefully consider the effect that sharp moves in interest rates may have on the performance of their mortgage security investment.
All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.