Types of Bonds
The Effect of Interest Rates on CMO Values and Prepayment Rates
Prevailing market interest rates affect CMOs in two major ways. First, as with any bond, when interest rates rise, the market price or value of most types of outstanding CMO tranches drops in proportion to the time remaining to the estimated maturity. Conversely, when rates fall, prices of outstanding CMOs generally rise, creating the opportunity for capital appreciation if the CMO is sold prior to the time when the principal is fully repaid.
Movements in market interest rates have a greater effect on CMOs than on other fixed-interest obligations because rate movements affect the underlying mortgage loan prepayment rates and, consequently, the CMO’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, homeowners are more likely to “stay put,” causing prepayment speeds to slow.
What’s good for the home buyer is not necessarily good for the CMO investor. If interest rates fall and prepayment speeds accelerate, CMO 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 would have on the performance of their CMO investment. (See also “negative convexity” in the Glossary.)
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.