Mortgage bonds are exposed to risk regardless of whether interest rates rise or fall, a situation complicated by the fact that fewer homeowners are locked into the ultralow interest rates seen during the pandemic than many assume. This dynamic impacts the predictability and stability of mortgage-backed securities.
The common perception is that a large segment of homeowners benefits from historically low mortgage rates. However, analysis suggests this group is smaller than anticipated. When rates are low, homeowners are less likely to refinance, and when rates rise, those with existing low rates are disinclined to move or take on new, more expensive mortgages. Both scenarios can create challenges for mortgage bonds, which are financial instruments backed by pools of mortgages.
If rates fall, homeowners with existing low rates might refinance into even lower ones, but the pool of these mortgages for securitization shrinks. Conversely, if rates rise, the incentive to move or refinance diminishes, also reducing the pool of new mortgages available for securitization and potentially leading to slower principal payments on existing bonds. This makes the behavior of mortgage holders a critical factor in assessing the risk associated with mortgage bonds.