Residential Mortgage Convexity in a Higher Rate Environment: Risks, Opportunities, and Portfolio Positioning

Key Takeaways

• Higher interest rates have created favorable yield opportunities in residential mortgages, but increasing rate volatility also pose significant risk.
• Mortgage coupon, purchase price, and loan seasoning strongly affect prepayment behavior and convexity across rate environments.
• For insurance investors, effective convexity management requires evaluating both prepayment and extension risk alongside asset-liability matching considerations.
• Option-adjusted spread analysis across a wide range of mortgage products helps investors find relative value without losing sight of convexity profile, credit quality, and downside risk.

Higher rates have pushed mortgage yields up and increased the complexity of managing mortgage portfolios. Durations are extending because homeowners have little reason to refinance, while insurers must match long-term liabilities, making convexity something to watch closely.

According to Scott Waterstredt, Managing Director and Senior Insurance Portfolio Manager at Bayview Asset Management, the current market poses a compelling risk-reward decision. While higher rates have improved new-money yields, elevated interest rate volatility requires investors to evaluate how mortgage assets may perform across a range of outcomes.

A Changing Interest Rate Environment

According to Waterstredt, five- and ten-year Treasury rates have risen about 100 basis points since May, increasing both yields and uncertainty for mortgage investors.
Higher borrowing costs are also placing renewed pressure on housing affordability and transaction activity. Although published affordability data showed modest year-over-year improvement through August, those figures did not yet reflect the more recent interest rate increase.

For investors, a heightened rate environment creates a market where attractive entry yields must be considered against the possibility of further rate increases or decreases and the potential for continued pressure on housing demand.

Rather than evaluating current yields in isolation, investors must consider how portfolio performance could change if rates move materially higher or lower.

Borrower Behavior and Mortgage Convexity

As interest rates have increased, much of the residential mortgage market has experienced duration extension. Borrowers with existing lower-rate mortgages have less incentive to refinance, resulting in slower prepayments and longer expected cash flow periods.

However, the current environment also offers investors greater flexibility in selecting mortgage assets with different coupon, pricing, and seasoning characteristics.
Newly originated, higher-coupon mortgages purchased at premiums may provide attractive current income but become more vulnerable to refinancing if rates decline. Conversely, lower-coupon, seasoned mortgages purchased near par or at discounts may have less immediate refinancing exposure but tend to offer less current income and retain significant extension risk if rates continue to rise.

Waterstredt noted that the opportunity set across these characteristics is broader than it has been over the past year or two. Rate volatility means loans originated over the last few months may have very different market coupons. While this provides more options for portfolio construction, it also reinforces the value of understanding the trade-offs among income generation, prepayment exposure, and duration risk.

Why Convexity Management Matters for Insurance Investors

Waterstredt opined that this rate environment has exposed the limits of some narrowly defined approaches to convexity management.

Some convexity management strategies focus on avoiding purchase premiums or favoring loans with prepayment penalties. Waterstredt said those approaches offer little protection against extension when rates rise, and borrowers stay in their loans longer. Investors who focused too narrowly on those features likely gave up current yield and still saw their duration extend.

Higher-coupon mortgages bought at a premium can work out differently. Waterstredt said investors who price these loans within a disciplined option-adjusted spread framework can benefit when prepayments come in slower than expected. Less of the premium gets amortized, which can push realized yield above the original prepayment assumption and partly offset the duration extension.

For insurers, the objective is not simply to minimize one type of mortgage risk, but to understand how different interest rate, credit, and housing market scenarios could affect cash flows and portfolio positioning.

Finding Relative Value Across Residential Mortgage Assets

With a wider opportunity set available, mortgage portfolio construction increasingly depends on evaluating relative value across several products and loan characteristics on a daily basis.

Waterstredt emphasizes an approach that does not rely on predicting interest-rate or housing-price direction. Instead, it focuses on maintaining access to a broad range of residential mortgage products and evaluating their risk-adjusted attractiveness through a consistent option-adjusted spread framework.

These opportunities may include mortgage products such as seasoned debt service coverage ratio (DSCR) loans, newly originated agency-eligible non-owner-occupied mortgages, Prime Jumbo, and other Non-QM mortgage loans. Each carries distinct prepayment, credit, and structural characteristics which affect expected performance.

Rather than favoring a specific coupon, price premium, or payment structure, investors can use option-adjusted spread to assess whether the expected return of a loan investment compensates them for the risk.

By applying consistent valuation methods across different mortgage products, investors can better identify opportunities that balance yield potential with credit quality and cash flow consistency.

Looking Ahead: Key Considerations for Insurers

As the market enters the next phase of the interest rate cycle, insurance investors face several key considerations.

One potential concern is a further increase in mortgage rates. Higher financing costs could further pressure housing affordability, weaken demand, and negatively affect home prices. At the same time, slower refinancing and housing turnover could extend duration further.

Credit risk also needs a close look. Waterstredt noted that with a fairly flat credit spread curve, investors get little extra compensation for taking on more mortgage credit risk, so selectivity matters more when evaluating new investments.

Insurers shouldn’t focus only on current income. They should check whether an investment still pays enough in less favorable scenarios, such as higher rates and weaker home prices.

The current residential mortgage market offers meaningful opportunities, but capturing them requires a comprehensive understanding of convexity risk in both rising- and falling-rate environments.

As Waterstredt emphasized, navigating today's market requires broad product choice, disciplined option-adjusted spread pricing, and an understanding of relative value across mortgage characteristics.

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