Question

1:Why is the duration of a mortgage-backed security not well-represented by the maturity date of the security?

Answer 1

There’s a difference between Maturity and Effective Maturity and it’s an important difference. Maturity measures the length of time in years it takes for a bond to complete payments of interest and principal. Most bonds pay their full face value or principal on the maturity date. The big exception is Mortgage Backed Securities, which pay back principal throughout the life on the bond.

Agency Mortgage Backed Securities, where effective maturity is 30 year, the effective duration is around 12 years. In addition to paying interest regularly, Mortgage Backed Securities pay back principal throughout the life of the bond. Like a treasury bond, the higher prevailing interest rates are, the shorter the duration. A one percent move in interest rates higher, would reduce the value of the bond by around 12%.

Thus, duration of a mortgage-backed security not well-represented by the maturity date of the security.