Yesterday I wrote about zero coupon bonds. They are principle only bonds (PO). There is another class of bonds that have home mortgages as collateral for the bonds. These mortgage backed obligations (MBOs) are usually rated AAA although you can buy lower rated securities. MBOs come in many different flavors and have different concentrations of collateral from different geographies.
MBOs have a peculiarity. The buyer of the bond does not know when the principle on the bond is going to be repaid. That is because in the US, when you mortgage a house, you almost always have the right to prepay the mortgage without penalty. This is important, because the average period of ownership is 5 years, and the basic mortgage is for 30 years.
The result of this free option to the home owner is that as interest rates fall, prepayments speed up. You get your money back when you can't reinvest it at the same rate as the security that got repaid. The industry refers to this as negative convexity. So while you do not have credit risk, you do have convexity risk or reinvestment risk. When interest rates go up, the term of the mortgage extends, going out to its final maturity.
Now go out and make some money!
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