medium · Asset-Backed Securities collateral
An investor holds a premium-priced Agency MBS. If interest rates fall, the investor faces 'Negative Convexity'.
Which scenario best illustrates the mathematical impact on the investor's return?
- The investor is forced to pay a contractual 'yield maintenance' penalty to the servicer, which offsets the lost interest income from all the prepaying loans.
- The 'available funds cap' mechanism is triggered, sharply limiting the interest rate paid to investors even as market rates for newly-originated loans keep dropping fast.
- Prepayments accelerate, forcing the investor to reinvest principal at lower rates while the 'premium' paid for the bond is amortized faster than expected, reducing yield.
- The bond's effective duration extends further as rates fall, making the position increasingly sensitive to additional declines and boosting the investor's realized capital gains.
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