Ahead of the MBS Curve: Generating Alpha in an Uncertain Prepayment Environment
Chief Solutions Officer
Agency residential MBS offer yields well above Treasury rates because those yields are subject to prepayment risk, namely, the risk that because of prepayments on the underlying mortgages the MBS will pay off earlier or later than expected. Accurate prepayment predictions are thus critical to retaining the higher yields of MBS; an accurate prediction can increase MBS investment value while an inaccurate one can create losses.
To understand these potential gains and losses requires answering the following question: what precisely is the value to an investor of a more accurate prepayment prediction? This answer has three parts: (1) how accurate is the prediction, (2) how inaccurate is the market's and (3) what is the value of the prediction’s greater accuracy?