Consulting Corner

MBS in 2003 or How I Learned to Love the Premium Bond
(with Apologies to Dr. Strangelove)
by Andrew Davidson

The continuing unrelenting rally has turned all mortgage investors into premium investors. In an upward sloping yield curve environment, premiums have risk and return characteristics that may appear odd to investors who are not familiar with IOs.

For this analysis we will examine three premium Fannie Mae 30 MBS with coupons of 5.5, 6.0 and 6.5. On May 16, all three were trading with prices between 103.75 and 104.5. The idea that the price spread between 5.5s and 6.5s has been crushed from 5 points to three-quarters of a point makes the market seem somewhat unreal, yet the situation gets even more confusing when we look at static spreads and OAS.

The Fannie Mae 6.0s, in the middle of the stack, have a static spread of 25 basis points (using a Z-spread to the swap curve assuming mortgage rates remain constant). This would seem like far too little compensation for the risk of a premium MBS, as there must be some option cost. Yet taking into account option cost, the OAS of the bond still turns out to be higher than expected at 16 basis points. It would appear that the option cost is only 9 basis points. While the 6s may be beyond the cusp point, 9 basis points seems woefully inadequate as an option cost.

Let's take a closer look.

In Table 1 we show various spread measures for the three bonds. In addition to the stable rate spread and the OAS, we also show the spread assuming that prepayments are driven by forward rates and illustrate the difference between the various spreads. The difference between the forward spread (which is also the zero volatility spread) and the OAS is the option cost. Note how, when measured in this way, the option cost varies from 48bp to 75 bp. These option costs appear to be more in line with expectations.

Table 1 also demonstrates the difference between the stable rate spread and the forward rate spread. These two numbers are calculated the same way, except for the prepayment rate. For the stable >>>