MBS Rally Convexity Play

This question focuses on how convexity works in mortgage-backed securities during a rally in the bond market. The candidate is asked to reason about the price-yield relationship of MBS when interest rates decline, and how embedded prepayment options alter that relationship. It probes understanding of why MBS often behave differently from plain vanilla government or corporate bonds and how this affects performance when yields move. This style of question is common in fixed income and securitized products interviews, especially for buy-side roles, rates desks, and mortgage trading or structuring positions.

To answer well, a candidate needs a solid grasp of duration and convexity, the impact of changing interest rates on bond prices, and how prepayment risk reshapes expected cash flows. It leans on intuition about option-like features embedded in MBS and how they affect risk-return trade-offs in different rate environments. Interviewers look for clear, consistent reasoning, an ability to connect option theory to fixed income behavior, and an understanding of how these properties influence portfolio positioning and hedging decisions in anticipation of rate moves.

What it tests

Convexity measures the curvature in the price-yield relationship of a fixed income security, quantifying how the duration of a bond changes as yields change. Positive convexity means that as yields fall, bond prices rise at an increasing rate, and as yields rise, prices fall at a decreasing rate. This effect is beneficial because it cushions losses when rates rise and amplifies gains when rates fall. Negative convexity, by contrast, reverses this effect: price gains are muted when yields fall, and losses are steeper when yields rise. The underlying reason is that embedded options (like prepayment in MBS) alter the bond's cash flows in a way that distorts the usual convexity advantage.