Investment Strategies in Mortgage-Backed Securities

A lot of money is being raised to invest in mortgage-backed securities (MBS). In this post, I'll try to analyze some of the strategies currently used by MBS funds, in particular how they put to work the different and sometimes opposite properties of some of these securities -- specifically, so as to hedge one security with another.

First, a pool of fixed-rate mortgages can collateralize two (or more) bonds: a floater, such as a CMO, and its complement, an inverse floater. The floater bond pays a coupon above LIBOR, and the inverse floaters pays some base coupon less LIBOR, the sum of both coupons being almost equal to the average coupon of the fixed-rate mortgage pool after subtracting some administrative costs and an arbitrage profit for the issuer.

Why arbitrage? Because there is demand for both products of the new structures: inverse floaters are useful to firms having floating assets and fixed liabilities, for example, and high-quality floaters are appealing to other players for symmetric reasons. In fact, a GNMA CMO is one of the few ways to get a floating bond rate, in large size, with explicit US Government support. This relatively high demand makes the coupons of the floaters and the inverse floaters relatively low, low enough for the issuer to squeeze in their spread.

A CMO can then be stripped into several bonds, including interest-only (IO) bonds and principal-only (PO) bonds. Note that, since the PO does not receive interest, the interest received from the collateral can be passed to the other bonds, increasing their coupon. For example, a $100mm pass-through paying 6% can be split into a $25mm PO and a $75mm bonds paying an 8% coupon. Each bond has opposite sensitivity to prepayment: since the holder of a PO bond gets their money back faster when prepayment accelerates, POs benefit then. In contrast, an Interest-Only (IO) pays interest for a shorter period if the loan is paid off earlier, so the mark of an IO suffers when prepayments accelerate. Because prepayment speeds depend in part on interest rates, POs tend to benefit and IOs tend to suffer when rates decrease.

An inverse IO (IIO) is an IO with an inverse floating coupon, created by carving out a floater from a fixed-rate bond but more typically from a CMO tranche. Again, the sum of the two floating coupons will be close to that of the original bond. For instance, an 8%-fixed bond can be split into a floater paying a coupon of L+50bp capped at 8% (the coupon thus ranging from 0.5% to 8%) and an inverse IO paying 7.5% less LIBOR, usually but not necessarily floored at 0%. IIOs and inverse floaters are frequently sold at deep discount and are eligible to financing in the form of relatively long-term repo. Because of the discount and leverage, IIOs and inverse floaters can offer very high yields when the yield curve is steep. Inverse IOs are thus a levered way to take advantage of slow prepayment speeds.

The duration of a floater is small – basically, equal to the time until the next coupon reset date. Its duration is definitively smaller than that of the original fixed-rate coupon, and the duration of the inverse floater is larger than that of the fixed-rate bond. (When rates increase, an inverse floater provides smaller coupons discounted at a higher rate.) The duration of an IIO, however, is extremely short or even negative – i.e., the price of an IIO can increase when rates increase.

That’s not the end of the slicing and dicing! The cash flows of a (non-IO) inverse floater can in turn be used to create a Two-Tiered Index Bond (TTIB). The coupons of a TTIB depend on LIBOR: if LIBOR stays in a first range a.k.a. “tier,” below a certain strike, a TTIB pays a relatively high fixed coupon. If LIBOR steps above the strike, the TTIB coupon becomes inversely proportional to LIBOR. The second tier is when the TTIB coupon reaches 0, at a LIBOR rate called the LIBOR cap. As a hedging tool, a TTIB is a security that hedges against low interest rates; the diagram of its coupon as a function of LIBOR has a “spread” shape: high and flat when LIBOR is below the strike, linearly decreasing to 0 when LIBOR is between the strike and the cap, and 0 above the cap.

Many of the bonds discussed above can show up as different tranches of the same CMO, thus based on the same collateral. The screen shot below shows the example of a Bank of America CMO. We can recognize several PO’s, several IIOS (showed as both “IO” and “INV”), and several floater (FLT) bonds.



Many hedge funds are currently assembling portfolios using the different securities described above, and use the different and sometimes even opposite properties of these securities to hedge one security with another: Portfolio duration can be reduced or neutralized using IIOs; prepayment sensitivity at the portfolio level can be hedged by mixing POs and IOs/IIOs; interest rate risk can be hedged by matching floaters with inverse floaters. The important point to take away here is that a long position can often be hedged by other long positions.