Key points
- Effective duration varies with prepayment risk (borrowers pay off mortgages when rates fall).
- Negative convexity: rates fall → prepayments accelerate → shorter duration, less price upside.
- Primary transmission mechanism for Fed policy to housing markets.
Example
A mortgage bond with a duration of about 6 might see that fall to about 3 if rates drop sharply and homeowners rush to refinance, which limits how much its price can rise.
In history
QE helped push 30-year US mortgage rates to a record low below 3% in 2021. When rates rose in 2022, refinancing stopped, MBS durations lengthened and prices fell.
Related terms