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Mike Sutherland Case ScenarioMike Sutherland is a mortgage-backed securities (MBS) analyst for a University endowment investment group and is evaluating the possible purchase of a MBS in the endowment’s fixed income portfolio. He is considering several U.S. government agency collateralized mortgage obligation (CMO) tranches. Because he is concerned interest rates will increase over the next 12 months, he wants to invest in a MBS-CMO rather than a pass-through MBS (MBS-PT). Sutherland’s additional investment objective is to purchase an MBS-CMO with principal repayments that approximate the principal repayment of a ‘bullet’ corporate bond. Selected characteristics for several MBS-CMO tranches are found in Exhibit 1. The current principal prepayment rate is 275 PSA.Exhibit 1Selected Tranche Information for CMO FNR 2005-XX *FLT is a floating-rate tranche with its coupon equal to 3 month LIBOR + 45 bpsOne of Sutherland’s colleagues asks if he considered purchasing an interest only (IO) stripped MBS-PT because its value should increase as interest rates rise. Sutherland replies that although the IO’s value should increase as interest rates rise above the contract rate, it is not an option because he can only purchase securities with principal repayments. As Sutherland continues his analysis, he decides to evaluate the MBS-CMO PAC Bond tranches on an option adjusted spread (OAS) basis. Sutherland wants to examine how changing interest rate volatility might affect the OAS and price for each MBS-CMO tranche. He summarizes his analysis in Exhibit 2.Exhibit 2OAS AnalysisInterest Rate Volatility of 10% and 30% Sutherland assumes a binomial interest rate tree model was used to calculate the OAS for the MBS-CMO PAC Bonds shown in Exhibit 2 because prepayment risk is just another form of call option risk. Sutherland then turns his attention to measures of duration for MBS-CMOs. He knows that MBS-CMO duration can be calculated by using Monte Carlo simulation, but that cash flow duration is an alternative measure. He believes that the cash flow duration measure is more reliable than Monte Carlo simulation because the former uses static principal prepayment assumptions to determine the bond values used to calculate the effective duration. |
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