CMOs and other structured securities

The spread duration of a CMO depends upon the deal structure and the tranche’s
payment seniority within the deal. If we assume that a widening (narrowing) of
spreads causes prepayments to decline (increase), a CMO with extension (contraction)
risk could have substantial spread risk. Also, it is important to remember that as
interest rates change, changes in CMO spreads may be different than changes
collateral spreads. For example, when interest rates fall, spreads on well-protected
PACs may tighten as spreads on ‘cuspy’ collateral widen, if investors trade out of
the more prepayment-sensitive passthroughs into structured securities with less
contraction risk. Therefore, when stress-testing a portfolio of mortgage-backed
securities, it is important to include simulation scenarios that combine changes in
interest rates with changes in spreads that differentiate by collateral type (premium
versus discount) and by CMO tranche type (e.g. stable PACs and VADMs versus
inverse floaters, IOs and so on).
PSA-linked index-amortizing notes (IANs) have enjoyed some degree of popularity
among some portfolio managers as a way to obtain MBS-like yields without actually
increasing exposure to mortgage-backed securities. Since the principal amortization
rate on these securities is linked to the prepayment speed on a reference pool of
mortgage collateral, one might think that the spread duration of an IAN would be
similar to the spread duration of the collateral pool. However, it is possible that
spreads on these structured notes could widen for reasons that do not affect the
market for mortgage-backed securities (such as increased regulatory scrutiny of the
structured note market). Therefore, when stress-testing a portfolio that includes both
mortgage-backed securities and IANs, it would be appropriate to simulate different
changes in spreads across these asset types.
To summarize, spread risk for corporate bonds is analogous to interest rate risk,
as a change in OAS produces the same change in price as a change in interest rates.

Spread duration for mortgage-backed securities reflects the fact that a change in
OAS affects the present value of expected future cash flows, but whether or not the
cash flows themselves are affected by the change in the OAS is a function of
assumptions made by the prepayment model used in the analysis. The spread
duration of a diversified portfolio measures the overall sensitivity to a change in
OASs across all security types, giving the portfolio manager important information
about a portfolio’s risk profile which no other risk measure provides. 223