Income Investing with Bonds, Stocks and Money Markets by Jason Brady

Author:Jason Brady
Language: eng
Format: epub
Publisher: McGraw-Hill Education
Published: 2012-03-14T16:00:00+00:00

FIGURE 4.2 Stocks and corporate bonds: bondholders have sold the upside option to stockholders.

To take a different asset class, MBSs (mortgage-backed securities) are an explicit example of the optionality present in fixed income. When a borrower takes out a mortgage in the U.S., the typical contract states that the borrower can refinance at any time. This means that when a homeowner with a mortgage needs to sell, he can sell his home and use the proceeds to pay off the mortgage debt, or a borrower can refinance that mortgage to a lower rate, even if he has no plans to move. Think about it from the lender’s standpoint. If you lend someone money at 6 percent to buy a house, you are expecting to get a 6 percent return (yield) on that note. If rates go to 3 percent, however, the borrower will likely not keep paying that 6 percent mortgage. Instead, he will refinance with a lower 3 percent loan. Conversely, if rates go to 9 percent, the borrower will likely keep the 6 percent loan and count himself lucky to have it.

This works out badly for the lender in both cases. In the first case, the lender is expecting to get 6 percent, and instead, because the borrower has the option to prepay the mortgage, the lender suddenly receives all of its money back. But when the lender goes to reinvest, rates are no longer at 6 percent, but instead have moved to 3 percent, so the return is halved. In the case of rates moving higher, the lender has lent money at a 6 percent rate, and because there is little chance of a borrower paying back the debt early, the borrower is stuck with the 6 percent loan when the new price for similar risk is 9 percent. Think about what happens to the price of the mortgage. On one hand, if rates fall, the lender is likely to get its money back quickly, so the price of the mortgage is not going to move much above par. In addition, because the borrower is likely to get its money back quickly, the duration of the loan decreases dramatically. On the other hand, if rates rise, the lender is unlikely to get its money back very quickly, because the borrower will wait as long as possible to give up that great 6 percent rate in a 9 percent world. As a result, the duration of the bond will be longer and the price will fall fairly quickly. So mortgages rise less in a falling rate environment and fall more in a rising rate one. It’s the worst of both worlds for the investor, and the way that the market makes up for this poor option profile is to demand a higher yield from the borrower.

So the optionality in the loan or in the bond (made up of a group of loans) has a dramatic effect on the duration of the bond and therefore also on the change in the bond’s price, given different interest rate moves.

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