Mortgage-backed securities prepayments

Thus the OAS is an indication of the value of the option element of the hond as well as the premium required by investors in return for accepting the default risk of the corporate bond. When OAS is measured as a spread between two bonds of similar default risk, the yield difference between the bonds reflects the value of the option element only. This is rare and the market convention is measure OAS over the equivalent benchmark government bond. OAS is used in the analysis of corporate bonds that incorporate call or put provisions, as well as mortgage-backed securities with prepayment risk. For both applications, the spread is calculated as the number of basis points over the yield of the government bond that would equate the price of both bonds. 

Although it is commonly quoted by market participants, the cash flow yield suffers from limitations similar to the yield to maturity. These shortcomings include (1) the projected cash flows assume that the prepayment speed will be realized (2) the projected cash flows are assumed to be reinvested at the cash flow yield and (3) the mortgage-backed or asset-backed security is assumed to be held until the final payoff of all the loans in the pool based on some prepayment assumption. If the cash flows are reinvested at rate lower than the cash flow yield (i.e., reinvestment risk) or if actual prepayments differ from those projected, then the cash flow yield will not be realized. Mortgage-backed and asset-backed securities are particularly sensitive to reinvestment risk since payments are usually monthly and include principal repayments as well as interest. 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

This chapter examines a number of issues relevant to participants in the fixed-income markets. The analysis presented is based on government-bond trading and is confined to generic bonds that are default-free, with no consideration given to factors that apply to corporate bonds, asset- and mortgage-backed bonds, convertibles, or other nonvanilla securities, or to issues such as credit risk and prepayment risk. Nevertheless, the principles adduced are pertinent to all relative-value fixed-income analysis. 

Some lending institutions penalize borrowers who retire their loans early. In the United States, prepayment penalties are levied only for commercial mortgages, not for residential ones (both are penalized in the United Kingdom). Residential lenders, therefore, cannot be certain of the cash flows they will receive. This is known as prepayment risk. The uncertainty of mortgages cash flows, and the risk associated with it, is passed on to the securities backed by the loans. In this way, an MBS is similar to a callable bond, with the call exercisable at the discretion of the borrowers, and, as will be explained later, it can be valued using a similar pricing model. 

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