There was a recent news article that spoke about the risk inherent in mortgage bonds, or Mortgage-Backed Securities (MBS). Finally! A well-read news source produced an article we actually agree with, and one that speaks to a major reason we have historically carried an underweight to the sector.
The article is about the negative convexity found in MBS. As a reminder, negative convexity is the result of the underlying optionality found in home loans.
- If rates fall, the underlying loans will refinance, resulting in these bonds being called away: it appreciates like a short bond when you want a long bond.
- However, if rates rise, the underlying loans remain outstanding for longer as they refinance at a much slower pace. It depreciates like a long bond when you want a short bond.
- You will often hear our team refer to this as “heads they win, tails you lose.”
This cash flow volatility is a real risk that is often overlooked and mispriced within fixed income, as witnessed by the vast exposure to MBS in the Bloomberg US Aggregate Bond Index (the “Agg”) and amongst our peers.
One argument against this train of thought is that spreads compensate investors for this cash flow volatility, and therefore investors can look past the negative convexity with confidence. However, in our experience, these spreads have been inadequate to compensate for the negative convexity inherent in these bonds, and today’s spread levels are no exception.
If there is little volatility and rates trade within a tight range, MBS will indeed be more competitive with other sectors. However, it is when we experience rate volatility that the risk of owning MBS becomes impossible to ignore.
Three-year horizon total return analysis (Illustrative performance)
Change in Interest Rates (Basis Points)
Sources: PTAM, Bloomberg, Intex, Yieldbook, Blackrock Anser, Interactive Data Pricing and Reference Data LLC as of 8/31/2026.
For illustrative purposes only. Not indicative of future results. We have generated Agency MBS to compare sectors the Firm invests in since it represents one of the largest sectors of the Bloomberg US Aggregate Bond Index. For MBS, we selected a generic MBS pool with similar coupon and loan age to new issue MBS pools. These total returns are estimated over a 3-year horizon. To create the Agency CMBS, and the 20-Year AA Taxable Muni, we take all the holdings in our portfolio that fall into those buckets and then create a weighted average (weight determined by position size) total return for each sector. The following bonds that are used to create the Shapes are held by PTAM clients as of the date of this presentation: Agency CMBS IO and
20-Year AA Taxable Muni.
Assumptions: (1) a parallel shift in the yield curve (2) static allocation for 3 years (3) linear rate changes (4) sector specific spreads are
held constant across five rate scenarios (5) reinvestment rate consistent with respective sector.
If interest rates are unchanged over the next 3 years, new issue Agency MBS will
roughly “tie” a combination of 30% 20-year Taxable Municipals and 70% Agency
Commercial Mortgage-Backed Securities (CMBS). It is in this rates-unchanged scenario that MBS presents its best potential performance on a relative and absolute basis. Put differently, in our view, MBS is essentially a bet on no rate volatility.
However, MBS is a great illustration of the potential benefit of viewing bonds like a motion picture (like with Shape Management) instead of a snapshot in time (like with yield and spread). In scenarios where interest rates rise or fall, the potential
outperformance over MBS is easily witnessed. As the magnitude of a potential
interest rate movement increases, so too does the potential for outperformance.
As we’ve seen time and time again with MBS products, in an environment withrate or spread volatility, what you see is not what you get. The reason for this is negative convexity, which can only be a detractor from your total return as rates move either higher or lower. The current yield and spread advertised by MBS are an investor’s absolute best-case scenario, and as the article states, mortgage bonds are at risk if rates rise – and if they fall.
Taylor acts as PTAM’s Client Portfolio Manager, serving as a liaison between investments, marketing, and sales. She is responsible for investment strategy updates and portfolio communications for all PTAM’s products. Taylor additionally leads production of various portfolio and market commentary as well as dedicated strategy content. Taylor received a Bachelor of Arts from the Princeton School of Public and International Affairs from Princeton University. She is also a CFA® charter holder.
Glossary
Yield Curve refers to the U.S. Treasury yield curve rates.
Risks and Other Important Considerations
By using Shape Management, PTAM creates projections of the performance of specific bonds or grouping of bonds. These projections are not the actual performance of any bond or product. As a result, Shape Management performance in this presentation were not actually achieved by any PTAM investment or product. The criteria and assumptions underlying the projected performance may prove to be incorrect. Prospective investors should not rely solely on such projected performance and should conduct a thorough independent analysis of the investment opportunity.
The tables included throughout this presentation are provided for illustrative and educational purposes only.
Projected performance results may have many inherent limitations. No representation is being made that an investment will, or is likely to, achieve profits or losses similar to those shown. In fact, there are frequently significant differences between projected performance results and actual results subsequently achieved. Although projected performance may be useful to consider when making an investment decision. Investment decisions based on Shape Management information may not be profitable.
All projected performance is shown as net performance, which includes management fees, reinvestment of interest payments, and principal payments. More details of security selection and methodology can be obtained by emailing mutualfunds@ptam.com.
Investing involves risk; principal loss is possible. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in asset-backed and mortgage-backed securities include risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. For a complete list of disclosures, please visit www.ptam.com.
When selecting a bond to invest in, most investors rely on what we refer to as “traditional fixed income metrics,” which are generally a combination of (1) taking a stance on whether interest rates will increase or decrease, (2) yield and (3) duration. Nearly 30 years ago, PTAM’s founders recognized the potential shortcomings in traditional bond metrics, and developed Shape Management, a math-based investment process that addresses each of these shortcomings by analyzing the risk return profile of a bond’s future cash flows. Shape Management is a mathematical calculation that analyzes the risk return profile of a bond’s or group of bonds’ future cash flows. By using Shape Management, PTAM creates projections of the performance of specific bonds or grouping of bonds. These projections are not the actual performance of any bond or product. As a result, Shape Management performance in this email were not actually achieved by any PTAM investment or product. The criteria and assumptions underlying the projected performance may prove to be incorrect. Prospective investors should not rely solely on such projected performance and should conduct a thorough independent analysis of the investment opportunity. The graphs included throughout this email are provided for illustrative and educational purposes only. Projected performance results may have many inherent limitations. No representation is being made that an investment will, or is likely to, achieve profits or losses similar to those shown. In fact, there are frequently significant differences between projected performance results and actual results subsequently achieved. Although projected performance may be useful to consider when making an investment decision. Investment decisions based on Shape Management information may not be profitable. All projected performance is shown as net performance, which includes management fees, reinvestment of interest payments, principal payments, and capital gains.
The information included is not an offer, recommendation or professional advice. Certain information contained herein has been obtained from third party sources and such information has not been independently verified by PT Asset Management, LLC. No representation, warranty, or undertaking, expressed or implied, is given to the accuracy or completeness of such information by PT Asset Management, LLC or any other person. While such sources are believed to be reliable, PT Asset Management, LLC does not assume any responsibility for the accuracy or completeness of such information. PT Asset Management, LLC does not undertake any obligation to update the information contained herein as of any future date. This email is confidential, is intended only for the person to whom it has been directly provided and under no circumstances may a copy be shown, copied, transmitted or otherwise be given to any person other than the authorized recipient without the prior written consent of PT Asset Management, LLC. Any indices and other financial benchmarks shown are provided for illustrative purposes only, are unmanaged, reflect reinvestment of income and dividends and do not reflect the impact of advisory fees. Investors cannot invest directly in an index. Comparisons to indexes have limitations because indexes have volatility and other material characteristics that may differ from a particular hedge fund. For example, a hedge fund may typically hold substantially fewer securities than are contained in an index. Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.
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