rate (or static) spread, we assume that the mortgage current coupon remains at its current level for the life of the mortgage; for the forward rate spread, the prepayment speeds are based on forward rates. Table 2 shows the prepayment rates and yields under the two assumptions. The difference between the two spreads is the forward cost. In this case there is a benefit. The steep yield curve slows down prepayments. These bonds gain in value as the high coupon is earned for a longer time. In this way, these bonds act like IOs.

The three bonds show varying levels of benefit, with the 6s and 6.5s gaining over 50 basis points of value from so-called "hedge value." Thus, the net OAS for these bonds represents a combination of a "hedge value" and option cost.

Some of this hedge value is exhibited in the average life. For example, the Fannie Mae 6 has an average life of about 1.3, which, under forward rates, can double to 2.6 years, yet its effective duration is only 0.6 years, as shown in Table 3.

This combination of features makes these bonds somewhat difficult to value and difficult to hedge. Changes in the level and shape of the yield curve and changes in prepayment expectations can have significant impact on value and risk.

Investors who have been involved with IOs recognize these features. For those who have avoided IOs in the past, the current market is providing a startling introduction to the characteristics of the IO features imbedded in premiums.

Table 1: FNMA 30yr on May 16, 2003

Net Coupon	OAS	Option Cost	Fwd	Fwd Cost	Stable
5.5	13	-75	88	-18	70
6.0	16	-63	79	-54	25
6.5	50	-48	98	-52	46

 

 

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