MBS Prepayment & Negative Convexity Hedging Spirals
Understanding Agency Mortgage-Backed Securities, prepayment risk, negative convexity, and institutional duration hedging flows.
1. Agency Mortgage-Backed Securities (MBS) & Prepayment Options
An Agency MBS pools thousands of residential mortgages guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. Unlike standard Treasuries, mortgage borrowers hold an embedded call option: the right to prepay and refinance their mortgage at any time without penalty when mortgage rates drop.
2. The Phenomenon of Negative Convexity
Because homeowners refinance during low-rate regimes and hold onto cheap mortgages during high-rate regimes, Agency MBS exhibit Negative Convexity:
- Rates Fall: Prepayments surge → Duration shortens (investors get cash back early when reinvestment yields are low). Price upside is capped.
- Rates Rise: Prepayments collapse → Duration extends (investors are locked into low yields for longer). Price declines accelerate.
3. Convexity Hedging Spirals in the Treasury Market
Institutional mortgage investors (pension funds, GSEs, mortgage servicers) must hedge the expanding duration of their MBS portfolios as rates rise. To do so, they aggressively sell 10-year and 30-year Treasury futures or pay fixed in interest rate swaps — creating an automated feedback loop that forces Treasury yields even higher.