We study the feedback from the risk of outstanding mortgage-backed securities (MBS) on the level and volatility of interest rates. We incorporate the supply shocks resulting from changes in MBS duration into a parsimonious equilibrium dynamic term structure model and derive three predictions that are strongly supported in the data: (i) MBS duration positively predicts nominal and real excess bond returns, especially for longer maturities; (ii) the predictive power of MBS duration is transitory in nature; and (iii) MBS convexity increases interest rate volatility, and this effect has a hump-shaped term structure. Mortgage-backed securities (MBS) and, more generally, mortgage loans constitute a major segment of US fixed income markets, comparable in size to that of Treasuries. As such, they account for a considerable share of financial intermediaries’ and institutional investors’ exposure to interest rate risk.1 The contribution of MBS to the fluctuations in the aggregate risk of fixed income portfolios over short to medium horizons is even more important. Indeed, because most fixed-rate mortgages can be prepaid and refinanced as interest rates move, the variation of MBS duration can be very large, even over short periods of time. In this paper we study the feedback from fluctuations in the aggregate risk of MBS onto the yield curve. To this end, we build a parsimonious dynamic equilibrium term structure model in which bond risk premia result from the interaction of the bond supply driven by mortgage debt and the risk-bearing capacity of specialized fixed income investors.

The equilibrium takes the form of a standard Vasicek (1977) short rate model augmented by an affine factor, aggregate MBS dollar duration, which captures the additional interest rate risk that investors have to absorb. Intuitively, a fall in mortgage duration is similar to a negative shock to the supply of long-term bonds that has an effect on their prices. In addition to duration itself, its sensitivity to changes in interest rates, measured by aggregate MBS dollar convexity, also plays a role. Because MBS duration falls when interest rates drop, mortgage investors who aim to keep the duration of their portfolios constant for hedging or portfolio rebalancing reasons will induce additional buying pressure on Treasuries and thereby amplify the effect of an interest rate shock. As a result, the MBS channel can simultaneously affect bond prices and yield volatility.