by Muhammad Humayun

Mortgage securities have their own unique risks compared to the conventional fixed income securities. It is important to understand the risks associated with mortgage securitiesbefore including them in a portfolio of investments. These securities are based on long-term commitments and are essentially associated with a higher default risk, but this is not all investors need to know before investing in mortgage backed securities.

Certainly, these securities provide higher yields to compensate for the additional risks involved, but what needs to be evaluated is if they actually provide higher risk adjusted returns or if they simply provide slightly higher returns along with a great addition to risk.

The following risks are associated with mortgage backed securities.

Spread Risk

A portfolio manager must evaluate the additional spread offered by mortgage backed securities compared to treasures of similar maturity. If the spread is large enough to compensate the investors for the additional risk involved, only then the manager should consider investing in mortgage securities.

Since, these securities have embedded options associated with them it is best to compare the option adjust spreads. It must be recognized that historical spreads do not always reflect the future spreads in an accurate manner.

Interest Rate Risk Assessment

The interest rate risk faced by mortgage securities is similar to that of the interest rate risk faced by treasury securities of similar duration. If the manager hedges the interest rate risk of the mortgage securities he earns an additional spread over treasuries. However, the spread can be significantly reduced due to the prepayment option available to the mortgagees.

Risk Assessment of Prepayments

The mortgagees might end up using the prepayment option available to them on their mortgages. This option of the mortgage securities increase the uncertainty of cash flows associated with these securities. Early payments are highly possible in a decreasing interest rate environment, when mortgagees will tend to refinance their current mortgages in order to benefit from lower interest rates.

The prepayment rates are initially estimated by the issuer of mortgage securities and the prepayment risk is that the prepayment rates might exceed the rates initially estimated by the issuer. The prepayment option results in the negative convexity feature of the mortgage securities.

Volatility Risk of Mortgage Securities

The volatility risk of mortgage backed securities is directly related to the interest rate movements. The value of the prepayment option depends on the interest rate volatility. In an environment where the interest rates are highly volatile, the value of the option feature sold to the mortgage holders increases and the option adjusted spread tends to be higher and vice versa for a decrease in the volatility of interest rates.

Model Risk

The prepayment rates of the mortgages are predicted using different prepayment models that incorporate expectations. These models are far from perfect and there is always a risk that the model is wrongfully specified and fails to anticipate the interest rates properly. This can lead to higher uncertainty of cash flows for these securities.

The understanding of these risk factors provides the portfolio manager with a unique insight into the factors that need to be considered before undertaking an investment in mortgage securities.