Why Mortgage-Backed Securities Offer Subpar Compensation for Convexity Risk in Today's Market

Mortgage-backed securities (MBS) have long been a cornerstone of fixed-income portfolios, prized for their yield, liquidity, and implicit government guarantees. However, in today's market environment, the compensation investors receive for bearing convexity risk in MBS portfolios is notably subpar. This underperformance stems from a unique confluence of factors: historically low prepayment rates, muted interest rate volatility, and the Federal Reserve's evolving monetary policy stance. To understand why MBS convexity payoffs are lagging, we must dissect the mechanics of prepayment risk and its distortion of convexity dynamics.

The Mechanics of Prepayment Risk and Convexity

Convexity in MBS refers to the sensitivity of a bond's duration to changes in interest rates. Unlike traditional bonds, which exhibit positive convexity (i.e., price appreciation accelerates as rates fall), MBS typically display negative convexity. This occurs because falling rates incentivize homeowners to refinance, shortening the effective duration of the security and limiting its price appreciation. Conversely, rising rates reduce prepayment risk, extending duration and amplifying price sensitivity.

The key driver of this dynamic is prepayment behavior. When mortgage rates decline below the coupon rate of existing loans, refinancing activity surges, accelerating cash flows and compressing duration. This creates a “drag” on MBS performance during rate declines, as the securities fail to fully capitalize on the price gains seen in positively convex assets like Treasuries.

The 2025 Paradox: Low Prepayment Risk and Flattened Convexity

In 2025, the MBS market is operating in a paradoxical environment. Mortgage rates have remained above 6% for much of the year, far exceeding the 2.5%–4% range of most existing mortgages originated in 2020–2021. As a result, refinancing activity has collapsed. According to the latest data, only 5.2% of the remaining principal balance in agency MBS pools has a coupon rate of 7% or higher—levels that would justify refinancing under current conditions. This has led to prepayment rates (measured by Constant Prepayment Rates, or CPR) remaining near all-time lows, with the Bloomberg U.S. MBS Index's convexity effectively flattened to near-zero levels.

The implications for convexity payoffs are profound. Normally, MBS investors are compensated for negative convexity through higher yields, as the risk of duration compression during rate declines is priced into spreads. However, in today's environment, the absence of prepayment risk has rendered this compensation unnecessary. The market is now pricing MBS as if they were traditional fixed-income securities with linear price behavior, despite their inherent structural characteristics. This mispricing is evident in the anomalous spread differentials between agency MBS and investment-grade corporates, which have widened to levels not seen since the Global Financial Crisis.

The Role of Quantitative Tightening and Rate Volatility

The Federal Reserve's quantitative tightening (QT) program has further distorted convexity payoffs. By reducing its holdings of agency MBS, the Fed has created a supply-side shock that temporarily widened spreads in 2022–2023. However, as QT has slowed—agency MBS holdings have been reduced by only $510 billion since May 2022, far below the original $35 billion/month pace—the market has stabilized. This has reduced the premium investors demand for convexity risk, as the threat of forced sales and spread widening has diminished.

Moreover, the Fed's cautious approach to rate cuts has kept interest rate volatility low. With the federal funds rate held steady at 4.25%–4.5% and no immediate rate hikes on the horizon, the traditional trade-off between convexity and duration has lost its urgency. Investors are no longer hedging against sharp rate declines, which historically drove demand for convexity compensation. Instead, MBS are being viewed as defensive assets with predictable cash flows, not as instruments requiring a risk premium for duration uncertainty.

Case Study: AGNC's Q2 2025 Struggles

The challenges of convexity mispricing are evident in the performance of mortgage REITs like AGNC Investment Corp. (AGNC). In Q2 2025, AGNC's $82.3 billion agency MBS portfolio faced a mismatch between actual and projected prepayment rates. While the firm projected a CPR of 7.8%, actual prepayment speeds reached 8.7%, accelerating premium amortization costs and eroding net interest income. This faster-than-expected prepayment activity created a negative convexity drag, reducing tangible book value by $0.44 per share.

AGNC's experience highlights a critical risk for MBS investors: convexity payoffs are only valuable when prepayment assumptions are accurate. In a low-prepayment environment, the benefits of convexity are muted, and unexpected refinancing activity can quickly erode returns. This is particularly problematic for leveraged portfolios, where even small deviations in prepayment speeds can amplify losses.

Investment Implications and Strategic Adjustments

Given the current market dynamics, investors should approach MBS with a nuanced understanding of convexity risk. Here are three key takeaways:

1. Reevaluate Convexity Premiums: The compensation for convexity risk in MBS is currently subpar due to low prepayment expectations. Investors should assess whether the yield spreads reflect the true risk profile of their portfolios, particularly as the Fed moves toward rate cuts.

2. Prioritize Defensive Characteristics: In a low-volatility environment, MBS offer unique defensive attributes. Their high-quality collateral and government guarantees make them attractive during equity market selloffs, as seen in Q2 2025 when the Bloomberg U.S. MBS Index outperformed both equities and corporates.

3. Monitor Prepayment Assumptions: As mortgage rates stabilize and refinancing incentives remain limited, prepayment models must be recalibrated. A sudden shift in rate expectations—such as a surprise Fed easing cycle—could reignite prepayment activity and reintroduce convexity risks.

Conclusion

Mortgage-backed securities are currently offering subpar compensation for convexity risk due to a combination of low prepayment activity, reduced rate volatility, and the Fed's policy trajectory. While this environment has stabilized MBS yields and made them appear attractive on a relative value basis, investors must remain vigilant. The distortion of convexity payoffs is a temporary phenomenon, and as the market anticipates rate cuts and QT unwinds, spreads are likely to narrow. For now, MBS can serve as a defensive, high-quality addition to fixed-income portfolios—but only if investors understand the evolving mechanics of prepayment risk and its impact on convexity.