Why Mortgage-Backed Securities Can Trade Above Par Below Mortgage Rates
Summary
The document asks why a 30-year Freddie Mac mortgage-backed security with a coupon below a quoted fixed mortgage rate can trade at a premium. The response first distinguishes the primary mortgage rate paid by borrowers from the coupon received by MBS investors. Guarantee and servicing fees reduce the investor’s effective interest income, so the quoted mortgage rate is not directly comparable with the security coupon.
The response attributes much of the remaining gap to prepayment assumptions and says that, for to-be-announced securities, the cheapest-to-deliver pool can also affect pricing. These points explain why comparing coupon and primary mortgage rate alone does not establish whether an MBS should trade above or below par. The answer assumes a front-month TBA price and a particular mortgage-rate quote, but the question does not identify the precise security or quote source; the explanation is therefore general rather than a valuation of that specific issue.
Key ideas
- The primary mortgage rate includes interest that MBS investors do not receive as coupon income.
- Guarantee and servicing fees reduce the interest passed through to investors.
- Prepayment assumptions contribute to the difference between mortgage rates and MBS pricing.
- For TBA securities, the cheapest-to-deliver pool can also influence price.
Tags
Full text
# Why are some MBS's with coupons below the FRM rate priced at a premium? # Why are some MBS's with coupons below the FRM rate priced at a premium? I'm looking at 30Y 4.0% Freddie Mac MBS prices as of yesterday, approximately 104:10. Meanwhile, 30Y FRM Freddie Mac quotes are 4.39%. Why are the MBS priced at such a premium, even though the coupon is below the interest rate? Does it have to do with prepayment assumptions? Could anyone please shed some light? Thank you! ## Answer by Joshua Ulrich (score 2, accepted) https://quant.stackexchange.com/a/10110 Here are some general contributing factors. I could be more specific, but you haven't given specifics about which Freddie, 30-year, 4% MBS price you are quoting. I'm going to assume it's the front-month TBA price. I'm also going to assume the 4.39% rate is the PMMS rate. The PMMS is the primary market rate (what the borrower pays). The investor doesn't receive the full primary rate. The investor receives the coupon. Freddie takes a portion of the interest as payment for guaranteeing the loan against default (the "guarantee fee" or "gfee"). And investors aren't interested in collecting payments, dealing with escrow, etc, so they pay a servicer to do that (the "service fee", or "base service fee"). These two fees can easily reduce the interest rate the investor receives by 50 basis points or more. As you guessed, the remainder of the difference between the PMMS and the current coupon MBS is largely due to prepayment assumptions. For TBAs, the cheapest-to-deliver pool is also a contributing factor. ## Answer by kris123456 (score 0) https://quant.stackexchange.com/a/21550 Please note, I am not from US market, so providing based on my views. MBS is a security and Bonds are also a security in our market. Both are backed by a type of mortgage. - The price movement action is primarily based on Demand Supply Ratio. I have seen bonds (as per your market, its MBS) below their Face value. - If the markets anticipates an interest rates rise, people invest in stocks of banks anticipating more profits for bank because of interest rate hikes. But money in a market is constant. In order to invest in one asset, holding assets should be sold. Bonds are sold, and the proceeds often gets invested into stocks. - Did we consider the Ratings/tranche(as per your market) of these? How secured are they? If markets anticipate risk in one sector, the corresponding MBS for these might go down.
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