What is contraction risk and why does it hurt MBS investors when rates drop?

Question

AcadiFi · Accepted Answer

Contraction risk is the risk that when interest rates fall, mortgage borrowers refinance en masse, returning principal to the MBS holder earlier than expected. The cash is fine — but reinvesting it at the new, lower yield destroys value. Consider Linnea Osterholm, who bought a 5.5% pass-through at par expecting a 7-year weighted average life. Rates drop 150 bps. Borrowers refinance; her WAL collapses to 3.2 years. She receives her principal back quickly and can only reinvest at 4.0%. The bond's price therefore rises far less than a comparable Treasury because the refi call cap truncates upside. This creates the MBS's signature negative convexity: price rises slower than a non-callable bond as yields fall, and falls faster as yields rise (extension risk). The convexity cost is quantified by OAS: an MBS trading at 50 bps OAS has spread equivalent to the nominal spread minus the optionality cost. ```mermaid flowchart TD R[Rates fall] --> F[Refinance
wave] F --> P[Principal
returns fast] P --> RI[Reinvest at
lower yield] RI --> L[Investor loss vs
non-callable bond] ``` Mitigants: buying premium-coupon MBS that are already refinanced (burnout), seasoned pools, or CMO support tranches structured to absorb excess prepayments.

What is contraction risk and why does it hurt MBS investors when rates drop?

Master Part I with our FRM Course

Related Questions

Practice Questions