Interest Rate Sensitivity in Mortgage-Backed Securities: Navigating the New Normal

The mortgage market in August 2025 is a study in contrasts. On one hand, refinancing activity remains robust, with the MBA's Refinance Index surging 23% week-over-week in early August, driven by a 30-year fixed-rate mortgage dipping to 6.67%—a level not seen since January 2025. On the other, adjustable-rate mortgage (ARM) applications, though slightly retreating, still hover near four-year highs, reflecting borrower appetite for lower initial rates amid a volatile rate environment. These trends are not merely statistical anomalies; they are critical signals for investors navigating the complex terrain of mortgage-backed securities (MBS) valuation and risk.

Refinance Activity: A Double-Edged Sword for MBS Valuation

The MBA's data reveals a refinance share of 46.1% for the week ending August 15, 2025, a figure that, while down slightly from the prior week's 46.5%, remains 23% above the same period in 2024. This sustained demand underscores a structural shift in borrower behavior, with homeowners actively seeking to lock in lower rates. However, this surge in refinancing accelerates prepayment speeds, a phenomenon that directly impacts MBS valuation.

When homeowners refinance, the underlying mortgages in MBS pools are paid off earlier than expected, shortening the securities' average life. For investors, this introduces prepayment risk, particularly for premium-purchased MBS. The accelerated amortization of premiums reduces book income, while the reinvestment of early proceeds at lower rates erodes returns. For example, the average loan size for refinances in August 2025 reached $366,400, indicating that high-balance borrowers—often more sensitive to rate changes—are driving this trend.

Mortgage REITs (mREITs) like NLY and AGNC, which rely on stable cash flows from MBS portfolios, have already felt the strain. Net interest margins for these firms have compressed by 30–40 basis points in Q3 2025, as refinancing outpaces expectations. Investors must weigh these margin pressures against the potential for higher cash flows from increased prepayments, a trade-off that demands careful portfolio management.

ARM Trends: Introducing Uncertainty into a Volatile Market

While refinancing activity dominates headlines, the rise in ARM applications—peaking at 9.6% of total applications in early August—signals a shift in borrower preferences. ARMs, with their lower initial rates and periodic rate resets, offer flexibility in a low-rate environment but introduce extension risk when rates rise. The 5/1 ARM rate climbed to 6.01% by August 15, 2025, reflecting market sensitivity to rate fluctuations.

This duality complicates MBS valuation models. Unlike fixed-rate mortgages, ARMs exhibit unpredictable prepayment behavior, as borrowers may delay refinancing due to rate uncertainty. For investors, this means greater price volatility in MBS and collateralized mortgage obligations (CMOs). The MBA's data also highlights a growing reliance on government-backed loans (Freddie Mac and Fannie Mae) for refinances, further diversifying the risk profile of MBS portfolios.

Strategic Implications for Investors

The interplay of refinance and ARM activity creates a high-stakes environment for MBS investors. Here are three key considerations:

1. Prepayment Hedging: Traditional static prepayment assumptions (e.g., CPR models) are insufficient in this climate. Investors should adopt dynamic hedging strategies, such as varying CPR assumptions based on rate scenarios, to mitigate prepayment risk.

2. Loan Characteristic Analysis: Focus on MBS with stable prepayment profiles. Loans with low rates, high loan-to-value (LTV) ratios, and older ages are less likely to prepay, offering more predictable cash flows.

3. Vector Analysis for CMOs: For complex securities like CMOs, vector analysis provides a more accurate assessment of performance under varying rate environments. This approach accounts for the interplay of prepayment speeds, rate resets, and cash flow timing.

Conclusion: Balancing Opportunity and Risk

The August 2025 MBA data paints a market in flux. While refinancing activity generates near-term cash flows, it also accelerates prepayments and compresses margins. Meanwhile, ARMs inject uncertainty into cash flow projections, amplifying price volatility. For investors, the path forward lies in agility: leveraging advanced modeling techniques, diversifying across loan types, and maintaining a keen eye on Federal Reserve policy.

In this environment, MBS remain a compelling asset class—but only for those willing to navigate its intricacies with precision and foresight. As the Federal Reserve contemplates its next moves, the ability to adapt to shifting rate dynamics will separate resilient portfolios from fragile ones.