Assessing the risks associated with prepayments

Reference no: EM131781350

Question: The following excerpt is taken from an article titled "Fidelity Eyes $250 Million Move into Premium PACs and I-Os" that appeared in the January 27, 1992, issue of bond Week, pp. 1 and 21:

Three Fidelity investment mortgage funds are considering investing this quarter a total of $250 million in premium planned amortization classes of collateralized mortgage obligations and some interest only strips, said Jim Wolfsan, portfolio manager. Wolfsan. will look mainly at PACs backed by 9-10% Federal Home Loan Mortgage Corp. and Federal National Mortgage Association pass-through. These have higher option-adjusted spreads than regular agency pass-through, or similar premium Government National Mortgage Association-backed, PACs, he said. He expects I-Os will start to perform better as prepayments start to slow later in this quarter.

The higher yields on I-Os and premium PACs compensate for their higher prepayment risk, said Wolfsan. "You get paid in yield to take on negative convexity," he said. He does not feel prepayments will accelerate.

a. Why would premium PACs and interest-only strips offer higher yields if the market expects that prepayments will accelerate or are highly uncertain?

b. What does Wolfsan mean when he says: "You get paid in yield to take on negative convexity"?

c. What measure is Wolfsan using to assess the risks associated with prepayments?

Reference no: EM131781350

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