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Why Falling Rates Can Raise Principal-Only Mortgage Bond Prices

Article Quant Q&A · Author: nsivakr
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Summary

The note answers whether principal-only mortgage bond prices or yields rise when interest rates fall. Its conclusion is that prices rise, with two mechanisms contributing. First, the usual bond price relationship applies: lower market rates increase the present value of a bond’s cash flows. Second, lower rates can encourage faster mortgage prepayments, changing when principal is expected to be returned.

The response explains the prepayment effect by comparing the resulting cash flows to those of a zero-coupon bond with an earlier maturity, which it says has a higher price. This is a concise conceptual explanation, not a pricing model or empirical study. It does not examine how prepayment uncertainty, borrower behavior, or the detailed structure of a mortgage pool may affect valuation.

Key ideas

  • Bond prices generally rise when market interest rates fall.
  • Lower rates can lead to faster mortgage prepayments.
  • Earlier expected principal repayment can increase the value of a principal-only bond.
  • The explanation is qualitative and does not model prepayment uncertainty.

Tags

Fixed income
Full text
# PO (Principal only) mortgage bonds - Does Price or yield go up when interest rates go down?


# PO (Principal only) mortgage bonds - Does Price or yield go up when interest rates go down?












I'm reading a book that states that PO mortgage bonds go up when interest rates go down as the prepayment happens faster.

I'm confused whether prices go up on PO bonds or yields go up?

## Answer by dm63 (score 3, accepted)

https://quant.stackexchange.com/a/70102

Prices go up. For 2 reasons a) just like any bond, prices go up when rates go down and b) faster prepayments are expected , which means the maturity of the bond becomes earlier than previously expected. Zero coupon bonds with earlier maturities have higher prices.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.