Fixed Income Analysis, Second Edition

CHAPTER 23

HEDGING MORTGAGE SECURITIES TO CAPTURE RELATIVE VALUE³⁵⁵

I. INTRODUCTION

Because of the spread offered on residential agency mortgage-backed securities, they often outperform government securities with the same interest rate risk and therefore they can be used to generate enhanced returns relative to a benchmark when the yield advantage of mortgage securities is attractive. However, to execute this strategy successfully, the prepayment risk of mortgage securities must be managed carefully. In this chapter, we will see how this is done. Specifically, we will see how to “hedge” the interest rate risk associated with a fixed rate mortgage security in order to capture the spread over Treasuries.³⁵⁶ Note that we use the terms mortgage-backed securities and mortgage securities interchangeably in this chapter. As explained earlier, the most basic form of mortgage-backed security is the mortgage passthrough security. Securities that are created from mortgage passthrough securities include collateralized mortgage obligations and mortgage strips (interest-only and principal-only securities).

II. THE PROBLEM

To illustrate the problem faced by a portfolio manager who believes that the spread offered on a mortgage security, is attractive and wants to hedge that spread, look at Exhibit 1. The exhibit shows the relationship between price and yield for a mortgage passthrough security. The yield for a mortgage security is the cash flow yield.³⁵⁷ The price-yield relationship exhibits ...