hard · Asset-Backed Securities
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 'yield maintenance' penalty to the servicer to compensate for the lost interest income from the prepaying loans.
- The 'available funds cap' is triggered, limiting the interest paid to the investor even as market rates for new loans are dropping.
- 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 duration extends as rates fall, making the position more sensitive to further rate declines and increasing capital gains.
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