- The typical 30-year mortgage bond repays part of the principal owed in addition to the monthly interest payment due each month. If all payments are made on a timely basis, approximately 3 percent of the outstanding principal amount on the loan is reduced, on average, each year. Mortgages usually allow for early prepayments of principal to the mortgage, either on a regular or irregular basis. Prepayment effectively reduces the maturity of the bond. Because Americans move from current residences about once every eight years, the effective maturity of a 30-year mortgage is closer to 10 than 30 years.
- Bonds may have stated maturities in excess of 10 years, often as much as 30 or 40 years. Bonds of municipal and corporate bond issuers regularly employ these long-term structures. Ten-year Treasury bonds have no extraordinary early redemption, or call feature. Ten-year bonds have balloon payment structures, such as all Treasury issues, meaning all principal is due on the maturity date. The United States government issues much of its debt as 10-year obligations; these issues are actively traded with narrow commission spreads by many bond participants. Mortgage pricing is greatly added by the efficiencies of the bond markets as a hedging vehicle.
- Individual mortgages are bundled by government agencies such as the FHA or Fannie Mae prior to public sale. The nature of the housing market is for these agencies to alert traders of their sale through regular auctions. Bond traders hedge, or offset, the interest rate risk of these very large mortgage commitments to offset the risk of loss from interest rate volatility. Hedging requires that the security being used to offset the mortgage risk be similar in bond length but of a different credit quality.
- The most appropriate security for hedging is the 10-year security. In a period of declining interest rates, when prepayments rise, the seven-year government bond is used. Note that basis for comparison is expected, not stated bond life. Mortgage bonds become increasingly unmarketable as their value rises above their maturity value, or par, because the risk of loss from prepayment is higher. Hedges must then be adjusted. When this happens, traders may use a combination of 10-year notes and Treasury bills and other short-maturity bonds.
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