Extension Risk

An investor owns mortgage-backed securities issued against many different pools of home loans. Interest rates fall and homeowners refinance in large numbers. What happens to her, and does holding many pools help?

1. A.She receives principal later than expected, and holding many pools makes it worse.Wrong. Refinancing accelerates repayment rather than delaying it, so the direction is reversed.
2. B.She receives principal later than expected, and holding many pools reduces the effect.Wrong. The direction is again reversed, and one rate move drives every pool in the portfolio at once.
3. C.She receives principal sooner than expected, and holding many pools removes the problem.Wrong. The direction is right, but a market-wide rate move reaches all the pools simultaneously.
4. D.She receives principal sooner than expected, and holding many pools does not help.Correct. Falling rates trigger refinancing everywhere, returning principal early for reinvestment at lower rates.

Why: Mortgage-backed securities pass through whatever homeowners pay, so when rates fall and borrowers refinance, principal returns sooner than the investor planned. That is prepayment risk, and its sting is that the returned money must be reinvested at the new lower rates. Because the trigger is the general level of interest rates, every pool prepays at once and holding more of them offers no protection. The mirror image is extension risk, where rising rates slow prepayments and leave the investor locked into a below-market yield for longer.

Ravi Chandrasekhar bought a pass-through mortgage-backed security at a time when mortgage rates were near their lows. Mortgage rates subsequently rise sharply and stay elevated. What happens to his security, and what is that risk called?

1. A.Prepayments accelerate and he must reinvest returned principal at lower rates; this is prepayment risk.Wrong direction. Prepayments accelerate when rates FALL, and rates here have risen.
2. B.The average life shortens, which cushions the price decline caused by rising rates.Wrong. Rising rates lengthen average life on a mortgage pass-through, deepening rather than cushioning the price decline.
3. C.Average life is fixed by the stated final maturity, so only the security's credit risk has changed.Wrong. Average life on a pass-through is driven by prepayment behavior, not by the stated final maturity.
4. D.Prepayments slow, the average life lengthens, and he stays locked into a below-market coupon just as rates rise; this is extension risk.Correct. Slower prepayments extend the security exactly when the investor would prefer to get principal back, which is extension risk.

Why: When mortgage rates rise, homeowners lose the incentive to refinance and are also less likely to move, so prepayments slow. Principal that the investor expected back early stays outstanding, the security's average life lengthens, and the holder remains locked into a below-market coupon for longer precisely when reinvestment rates have improved. That combination is extension risk, and it is why mortgage-backed securities exhibit negative convexity: they shorten when rates fall and lengthen when rates rise, the opposite of what an investor would want in each case.

Corliss Capital structures a collateralized mortgage obligation that includes a Z-tranche. Until the earlier tranches are fully retired, the Z-tranche:

1. A.Receives interest payments but no principal until the earlier tranches are retired.That describes an ordinary sequential-pay tranche. The Z-tranche does not receive even the interest in cash.
2. B.Is paid principal first, ahead of every other tranche in the deal.That is the first sequential tranche. The Z-tranche sits at the opposite end of the payment waterfall.
3. C.Is guaranteed as to principal and interest by the U.S. Treasury.CMO tranches are not Treasury obligations. Any guarantee comes from the agency or issuer behind the collateral, not the Treasury, and it does not change tranche mechanics.
4. D.Receives no cash payments at all; its accrued interest is added to its principal balance, making it the longest and most price-volatile tranche in the structure.Correct. Accrual rather than payment is the defining feature, and the compounding balance is what drives the extreme volatility.

Why: A Z-tranche, also called an accrual tranche, is the deferred-interest piece of a CMO. While earlier tranches are being paid, the Z-tranche receives no cash at all; its interest is accrued and added to its principal balance. Because it receives nothing for years and then has a swollen balance, it has the longest average life and the greatest price volatility in the structure. Review CMO tranche types in the debt securities topic.

Corliss Capital structures a collateralized mortgage obligation containing a planned amortization class (PAC) tranche and a companion (support) tranche. Mortgage rates then fall sharply and prepayments run far above the speeds assumed at issue. What happens to the two tranches?

1. A.The PAC keeps to its scheduled principal payments within its designed band, while the companion absorbs the excess principal and is retired far earlier than expectedCorrect. The companion exists to take the surplus so the PAC's schedule holds.
2. B.Both tranches receive the accelerated principal proportionally, because prepayments pass through a CMO pro rata to all classesPro rata pass-through describes a plain mortgage pass-through. The entire purpose of a CMO is to allocate principal by rules rather than proportionally.
3. C.The PAC's principal payments are deferred, because fast prepayments are applied first to the tranche with the longest average lifeDeferral is what happens to a companion when prepayments SLOW. Fast prepayments accelerate principal, they do not defer it.
4. D.The companion keeps to its schedule while the PAC absorbs the excess principal, which is why the PAC yields moreThe roles are reversed. The PAC is the protected tranche and yields less because of that protection.

Why: A PAC is engineered to deliver a stated principal schedule so long as prepayments stay inside a designed band of speeds. The companion tranche is the shock absorber that makes that promise possible. When prepayments accelerate, the surplus principal is routed to the companion, which is retired far ahead of its expected average life while the PAC keeps paying on schedule. The relationship runs the other way too: if prepayments slow, the companion's principal is deferred and its life extends. That two-sided volatility is why a companion is priced to yield more than the PAC in the same deal.