Fixed Income — Structured Products

Core Concepts

MBS Pass-Throughs

A pool of mortgages whose cash flows (principal, interest, prepayments) are passed through to investors on a pro-rata basis. Agency MBS (Ginnie Mae, Fannie Mae, Freddie Mac) carry a government or GSE guarantee against credit losses, isolating prepayment risk as the primary concern. Non-agency MBS lack this guarantee and carry both credit and prepayment risk.

Prepayment Risk

Borrowers can refinance when rates drop, returning principal early. This creates negative convexity — when rates fall, MBS prices rise less than comparable Treasuries because prepayments accelerate and shorten the bond's effective life. Prepayment risk has two faces:

Contraction risk: Rates fall, prepayments accelerate, duration shortens. Investors receive principal back when reinvestment rates are lower.

Extension risk: Rates rise, prepayments slow, duration extends. Investors are locked into below-market coupons for longer than expected.

PSA Prepayment Model

The Public Securities Association model provides a benchmark prepayment speed:

100% PSA = ramp from 0% CPR to 6% CPR linearly over the first 30 months, then constant at 6% CPR thereafter.