A Bond Refresher on RMBS Pricing

A conversation I had with Gemini from Google explaining how pricing works on an RMBS security.

I’d be glad to help with your bond questions! Please feel free to ask away, and I’ll do my best to provide you with accurate and helpful information.

Here are some common bond-related topics that you might be interested in:

  • Bond basics: What are bonds, how do they work, and what are the different types of bonds?
  • Bond valuation: How is the price of a bond determined, and what factors affect its value?
  • Bond yields: What is a bond’s yield, and how is it calculated?
  • Bond risks: What are the risks associated with investing in bonds, and how can they be managed?
  • Bond strategies: How can bonds be used in an investment portfolio, and what are some common bond investment strategies?

Feel free to ask your questions about any of these topics, or anything else related to bonds!

What are forward rates?

Forward rates are interest rates that are applicable to a financial transaction that will take place in the future. They represent the market’s expectation of what interest rates will be at a specific point in time.  

Here are some key things to understand about forward rates:

  • Derived from the yield curve: Forward rates are typically calculated from the yield curve, which plots the yields of bonds with different maturities. The shape of the yield curve reflects the market’s expectations about future interest rates.  
  • Predict future interest rates: Forward rates can be seen as a prediction of where interest rates are likely to be in the future. For example, a one-year forward rate starting six months from now represents the market’s expectation of what the one-year interest rate will be six months in the future.  
  • Used for pricing and hedging: Forward rates are used in various financial transactions, including pricing derivatives, hedging interest rate risk, and making investment decisions.  
  • Reflect market expectations: Forward rates reflect the collective expectations of market participants about future economic conditions, including inflation, monetary policy, and economic growth.  
  • Not guaranteed: It’s important to remember that forward rates are just expectations. Actual interest rates in the future may differ from the forward rates.  

In summary: Forward rates provide valuable insights into the market’s expectations about future interest rates. They are important tools for pricing, hedging, and making investment decisions. However, it’s crucial to remember that forward rates are just predictions and actual interest rates may deviate from them.  

Let me know if you have any further questions about forward rates or other aspects of bonds!

If a 1 year treasury bond is yielding 4% and a 2 year treasury bond is yielding 3%, is the market predicting that one year from now the 1 year bond will be yielding 2%?

Yes, you’re exactly right! This is a fundamental principle of how forward rates are derived from the yield curve.

Here’s the breakdown:

  • The Current Situation: We have a 1-year bond yielding 4% and a 2-year bond yielding 3%.
  • The Implication: This suggests that the market believes interest rates will be lower in the future. Otherwise, why would investors accept a lower yield on the 2-year bond compared to the 1-year bond?
  • The Forward Rate Calculation: The math behind this involves ensuring that an investor would be indifferent between investing in the 1-year bond today and rolling it over into another 1-year bond a year from now, versus investing in the 2-year bond today and holding it to maturity. To make these two investments equivalent, the implied forward rate for the 1-year bond one year from now must be 2%.

Key Takeaway: The yield curve, and the relationship between the yields of different maturity bonds, provides insights into the market’s expectations of future interest rates. In this case, a downward sloping yield curve (where longer-term bonds have lower yields) signals an expectation of lower interest rates in the future.  

How often are these “predictions” correct?

The accuracy of these “predictions” embedded in the yield curve is a complex topic, with no simple answer. Let’s explore this further:

Accuracy is Mixed

  • Sometimes accurate: There are many historical instances where the yield curve has successfully predicted future interest rate movements. For example, an inverted yield curve (where short-term rates are higher than long-term rates) has often preceded recessions, during which interest rates tend to fall.
  • Sometimes inaccurate: However, the yield curve is not a foolproof predictor. There have been times when the market’s expectations, as reflected in the yield curve, did not materialize. Economic conditions, central bank policies, and unforeseen events can all disrupt the anticipated path of interest rates.

Factors Affecting Accuracy

  • Market Efficiency: The efficiency of the market plays a crucial role. In an efficient market, the yield curve should accurately incorporate all available information and reflect the most likely future scenario. However, markets are not always perfectly efficient and can be swayed by emotions and speculation.
  • Economic Uncertainty: The greater the economic uncertainty, the less reliable the yield curve’s predictions become. Unexpected shocks, geopolitical events, or changes in central bank policy can significantly impact future interest rates, even if the market didn’t initially anticipate them.
  • Time Horizon: The accuracy of yield curve predictions also tends to vary depending on the time horizon. Short-term predictions (e.g., one year ahead) are generally more reliable than longer-term predictions (e.g., five or ten years ahead) due to the greater uncertainty involved in forecasting further into the future.

Key Points to Remember

  • The yield curve provides valuable insights into the market’s expectations about future interest rates.
  • While these predictions can be helpful, they should be treated with caution and not as guarantees.
  • It’s important to consider other factors and economic indicators when making investment decisions.

In summary: The yield curve’s predictive power is not perfect, but it can offer valuable guidance, especially when combined with other economic analyses. It’s best used as one tool among many to understand the potential direction of interest rates.

If you’d like to delve deeper into the relationship between yield curves and market predictions, I’m happy to discuss specific examples or provide additional resources!

What are the two factors that determine the prices of a residential mortgage backed security?

The two primary factors that determine the prices of a residential mortgage-backed security (RMBS) are:

  1. Interest Rates:

    • Inverse Relationship: RMBS prices have an inverse relationship with interest rates. When interest rates rise, the value of existing RMBS decreases, and vice versa.  
    • Reasoning: This is because new bonds issued at higher interest rates will offer more attractive yields to investors than the older RMBS with lower coupon rates. To compete, the older RMBS must be sold at a discount (lower price) to increase their effective yield.
  2. Prepayment Risk:

    • Definition: Prepayment risk refers to the possibility that homeowners will refinance their mortgages or pay them off early when interest rates fall.  
    • Impact on RMBS: This early repayment disrupts the expected cash flow from the underlying mortgages, potentially reducing the yield for RMBS investors. Therefore, RMBS with higher prepayment risk tend to be priced lower to compensate investors for this uncertainty.  

Additional factors that can influence RMBS prices:

  • Credit Risk: The credit quality of the underlying mortgages affects the risk of default and, consequently, the value of the RMBS. RMBS backed by mortgages with higher credit scores generally have lower credit risk and are priced higher.  
  • Economic Conditions: The overall economic climate can influence prepayment rates and default risk. In a strong economy, homeowners may be more likely to refinance or move, leading to higher prepayment risk. Conversely, during economic downturns, default risk may increase, impacting RMBS prices.  

Remember: RMBS pricing is complex and influenced by various factors. Understanding the key drivers, particularly interest rates and prepayment risk, can help investors make more informed decisions when considering RMBS investments.  

Does this mean that their is an embedded “option” in the price of the security that reduces the price of the security

Yes, you are absolutely correct! The prepayment risk associated with RMBS can be viewed as an embedded option, specifically a call option held by the homeowners.

Here’s why:

  • Call Option Analogy: A call option gives the holder the right, but not the obligation, to buy an asset (in this case, their mortgage) at a predetermined price (the remaining mortgage balance) before a specific date (the maturity of the mortgage). Homeowners essentially have this call option through their ability to refinance or prepay their mortgage.

  • Impact on RMBS Price: When interest rates fall, homeowners are more likely to exercise this “call option” by refinancing at a lower rate. This early repayment disrupts the expected cash flow from the underlying mortgages backing the RMBS, potentially reducing the overall yield for RMBS investors.

  • Price Reduction: To compensate investors for this prepayment risk (or embedded call option), RMBS are typically priced lower than they would be without this risk. The greater the prepayment risk, the larger the discount on the RMBS price.

Key Points:

  • Prepayment risk acts like an embedded call option in RMBS.
  • This option benefits homeowners, giving them the flexibility to refinance when rates fall.
  • RMBS investors bear the cost of this option through lower security prices.
  • The magnitude of the price discount depends on the perceived likelihood of prepayment.

In essence, the price of an RMBS reflects not just the underlying mortgages’ cash flows but also the value of this embedded call option held by homeowners. Understanding this dynamic is crucial for investors to accurately assess the risk and return potential of RMBS investments.

So if interest rates are expected to drop, I assume that means that lower coupon securities have lower prepayment risk, and thus, the value of the embedded option is lower. And securities with a higher coupon would have a much higher value on the embedded option. Could the value of the option be enough so that the higher coupon security sells for a lower price than the lower coupon security?

Yes, you’re absolutely correct! Your understanding is spot on.

Let’s break down the key points:

1. Impact of Falling Interest Rates

  • Lower Coupon Securities: When interest rates are expected to drop, homeowners with lower coupon mortgages are less likely to refinance because they already have a relatively low interest rate. This translates to lower prepayment risk for RMBS backed by these mortgages, and hence a lower value for the embedded call option.
  • Higher Coupon Securities: Conversely, homeowners with higher coupon mortgages have a strong incentive to refinance to take advantage of lower rates. This creates a higher prepayment risk for the corresponding RMBS, increasing the value of the embedded call option.

2. Option Value and Security Price

  • Lower Coupon Securities: Due to the lower prepayment risk, these securities will have a less significant price discount associated with the embedded option.
  • Higher Coupon Securities: The higher prepayment risk will result in a larger price discount to compensate investors for the potential loss of future interest payments if homeowners refinance.

3. Price Inversion

  • Possibility of Inversion: It is indeed possible that the price discount associated with the higher prepayment risk (and higher option value) on the higher coupon security could be so substantial that it ends up selling for a lower price than the lower coupon security, even though the higher coupon security would generate more cash flow if held to maturity.

Key Takeaway

The embedded call option in RMBS, driven by prepayment risk, is a significant factor affecting their prices. When interest rates are expected to decline, the value of this option increases for higher coupon securities, potentially leading to a price inversion where they trade at a discount to lower coupon securities.

Important Note: This phenomenon highlights the importance of considering both the underlying cash flows and the embedded optionality when evaluating RMBS investments.

Week Ending 9/6/2024

MARKET RECAP

  • Overall Market Performance:

    • The SP500 lost 4.25% and the Nasdaq dropped 5.77%. NVDA dropped by 13.86% and AVGO by 15.86%.
    • The S&P 500 fell for three consecutive days leading up to the August jobs report.
    • Tech stocks saw a significant selloff on Friday, resulting in the Nasdaq’s worst week since early 2022.
    • The market downturn was triggered by growth worries, a possible recession, and a subsequent drawdown in earnings.
  • Key Economic Data:

    • August jobs report: 142,000 jobs added, below expectations of 165,000. Prior two months were revised down by 85,000.
    • Unemployment rate dropped to 4.22% from 4.26%.

SCOREBOARD

Week Ending 8/30/2024

MARKET RECAP

  • US stocks +0.28%, international stocks -0.11%, bonds -0.52%.
  • For August, US stocks +2.13%, international stocks +2.41%, bonds +1.46%.
  • Q2 GDP raised to 3.0%.
  • PCE comes in at 2.5% as the inflation continues to subside.
  • NVDA falls 7.73% on the week despite topping earnings and sales forecasts and authorizing a $50 billion buyback.

SCOREBOARD

Week Ending 8/16/2024

MARKET RECAP

  • Markets were on fire, US stocks +3.9%, NASDAQ +5.3%, VXUS +3.51%, and bonds +0.51%.
  • Fears of a recession were declining this week. Goldman Sachs cuts recession risk in the next year to 20% from 25%. Retail sales were up a strong 1%, jobless claims were falling, and economic data such as restaurant bookings, hotel occupancy, and air travel appeared fine.
  • But homebuilders started on fewer projects than what was projected.
  • Inflation news was good; wholesale prices were lower than expected, and the CPI, up 2.9%, showed inflation is slowing.

SCOREBOARD

Week Ending 8/9/2024

MARKET RECAP

  • US stocks ended up flat on the week, an incredible achievement considering the Monday scare.
  • On Monday, the Japanese Topix fell by 12.2%, its biggest loss since October of 1987. Nasdaq fell by 3.4%, the S&P 500 -3.0%. The unwinding of the carry trade and scares of a hard landing propelled the selloff.
  • The VIX got as high as the mid 60s and was at its highest level since the 2020 Covid bear market.
  • There were economic fears that the Fed was way behind the curve. But the Institute of Supply Management’s service index offered some encouragement, rising to 51.4 from 48.8 in June. More positive news later in the week: Initial jobless claims came in at 233,000, a decline of 17,000 and lower than the estimate, helped calm the market.

SCOREBOARD

Week Ending 8/2/2024

MARKET RECAP

  • US stocks were down by 2.52% for the week, international stocks by 2.72%, bonds had a monster rally, up by 2.36%.. The Russell 2000 was down by 6.7%. The Dow fell 600 points on Friday. The NASDAQ is now down just over 10% from its  July 10th high and is in correction territory. The 10-year yield fell more this week than any time since March of 2020.
  • There was a sharp slowdown in jobs in July, up by 114,000, falling short of the expectations of 170,000. The unemployment rate increased to 4.3%, a three-year high. Average hourly earnings were up by 3.6% yearly, the lowest gain since May of 2021.
  • The VIX closed at its highest level of the year.
  • The Sahm Rule was triggered, an early recessionary indicator.
  • But hard economic data still points to more of a soft landing than a hard one. According to Torsten Slok, Chief Economist at Apollo, “There are no signs of a slowdown in restaurant bookings, TSA air travel data, tax withholdings, retail sales, hotel demand, bank lending, Broadway show attendance, and weekly box office grosses. Combined with GDP in the second quarter coming in at 2.8%, the bottom line is that the current state of the economy can be described as slowing, but still a soft landing.”

SCOREBOARD

Week Ending 7/26/2024

MARKET RECAP

  • Stocks ended the week on a high note but are down for the week. US stocks fell by 0.51%, and international stocks by 0.20%. However, the Dow Jones Industrial Average finished up 0.75%. The S&P Small Cap 600 was up by 3.6% for the week. Bonds rallied by 0.28%.
  • Good inflation data helped small caps and the Dow. The personal consumption expenditures price index was up only 2.5%, and in the second quarter, GDP came in better than expected at 2.8%. To investors, this was the right mix to suggest a rate cut in September.
  • The NASDAQ was down by 2.1% for the week. On Wednesday, the index fell by 3.6%, its worst day since 2022. At its low point on Thursday, the MAG 7 was off by 14% from its high on July 11th.
  • On Thursday, copper ended its longest losing streak since February of 2020.

SCOREBOARD

Week Ending 7/21/2024

MARKET RECAP

  • US stocks decline by 1.66% and international stocks by 2.64%. US small caps increased by 1.7%. The NASDAQ was off by 3.65%.
  • On Wednesday, the Nasdaq had its worst day in two years due to fears of tighter regulation on chip sales to Congress.
  • Fears of a trade war weighed on the market as the week progressed, courtesy of the Trump/Vance platform.
  • On Friday, a worldwide software failure impacted businesses almost everywhere due to one line of bad code written by Crowdstrike.

TRUMP

Trump had a chance to make a positive statement at the Republican National Convention. Just a few days after the assassination attempt, with most of the entire country ready to give him a chance, he could have made an honest attempt to broaden his coalition and act like he wanted to unite the country. But just like you would think, he opened up his speech with most of the right notes, but it quickly deteriorated into a rambling, hateful, attack-filled, dark diatribe about Democrats and the current state of the world and the country. Of which, of course, only he could solve, often in as little as a day or two, and simply with a phone call. Trump is crazy, and while the Republican convention-goers swallow it up hook, line, and sinker, most of the rest of the nation realizes he is as bad as ever.

He delivered the longest presidential nomination acceptance speech on record; almost all of it was rambling and off the cuff. Trump is mad at the world and paranoid, believing that he has magical powers to solve problems immediately and that only he can do this.

Even with that, he leads in the polls because Biden appeared frail and unable to continue as President. Today (Sunday), Biden announced that he will withdraw from the race, so the Dems have a chance to rally now and can win if they nominate the right person. Kamila Harris appears to be that nominee, and I would not consider her the right person.

Trump is a weak candidate. And I say this knowing full and well that the Republicans left the convention all fired up and confident in what was a high-energy and well-run event, sure that they will win in November.

But as described above, Trump is still Trump, and he is not mentally well, and the voters in the middle understand that, and they will tilt the election, one way or the other. The big problem with the Democrats is that their policies, which seem to be driven by the far left, are so bad and so harmful for America and its culture that a lot of the middle will lean towards Trump despite his meanness, craziness, and mental instability.

If only there were a reasonable centrist candidate. But at least for now, there isn’t so that Americans will be faced with two bad choices. Let’s hope.

SCOREBOARD

Week Ending 7/12/2024

MARKET RECAP

Here are the highlights for the financial markets for the business week ending July 12, 2024:

-There was an attempted assassination of Donald Trump. Fortunately, the former President survived. Hopefully, some good comes out of this, and we can move forward as a more civil society and respect opinions even when they differ from our own. That is what each party is now pledging.

– The Dow closed above 40,000 for the second time, buoyed by gains in various sectors. The index hit intraday record highs on Friday.

– **Bank Earnings**:
– Wells Fargo’s shares dropped over 5% following their quarterly results, while JPMorgan Chase remained stable, and Citigroup advanced. Analysts expect major banks to increase reserves to cover declining loans, impacting their earnings.

– The June Consumer Price Index (CPI) fell by 0.1%, marking the first monthly decrease in over four years, reinforcing expectations of an interest rate cut by the Federal Reserve in September.
– The market is now pricing three rate cuts by the end of January 2025.

– Jobless claims for the week ending July 6 decreased to 222,000, indicating a stable job market.

Overall, the week was marked by gains in major indexes, a shift in investor focus from large-cap tech stocks to smaller companies, and significant movements in bank stocks following earnings reports. Inflation data and expectations of Federal Reserve rate cuts played a crucial role in shaping market sentiment.

SCOREBOARD