Module 12 · Advanced
MBS, OAS & negative convexity
A mortgage-backed security (MBS)is a pool of home loans packaged into a bond — you collect homeowners' monthly payments. But there's a twist no ordinary bond has: homeowners can prepay. When rates fall, they refinance, handing your principal back early — right when you'd most want to keep collecting that high coupon.
That single feature flips the normal rules. A regular bond gains more and more as rates fall (positive convexity). An MBS caps out: as rates drop below the mortgage coupon, prepayments accelerate and the price stops rising — even rolls over. That's negative convexity — you get the downside of rising rates but not the full upside of falling ones. To compensate, MBS pay an extra yield called the OAS(option-adjusted spread) — the reward for being short the homeowner's prepayment option. See the two curves diverge below.
🎛 MBS vs a normal bond
MBS price
101.95
Normal bond price
134.76
Prepayment speed
58% CPR
A mortgage-backed security is a pool of home loans — but homeowners can prepay (refinance) when rates fall. The chart runs rates high→low (left→right). A normal bond (grey) keeps rising as rates fall. The MBS (amber) rolls over and caps: as rates drop below the mortgage coupon, prepayments accelerate (see the CPR jump), handing your principal back early right when you'd want to keep the high coupon. That's negative convexity— the curve bends the wrong way — and it's why MBS pay extra yield (the OAS, option-adjusted spread) to compensate. Educational tool — not investment advice.
Things to try
- • Drag the market rate below the coupon — the CPR (prepayment speed) jumps and the amber MBS curve flattens while the grey bond keeps climbing.
- • Compare the two lines at low rates — the gap is what the prepayment option costs you.
- • Lower the coupon — the bond is less “in the money” to refinance, so prepayments (and the cap) kick in later.