Why do MBS yields move when the Fed changes rates?

MBS investors receive both interest and principal. When rates fall, homeowners refinance more often, paying off loans earlier than scheduled. This speeds up principal return to investors, who must then reinvest at lower prevailing rates—reducing overall yield. Conversely, rising rates slow refinancing, extending loan life and locking in higher yields—but also increase duration risk if rates keep climbing.

This sensitivity to interest rate paths is measured as ‘convexity’—a key metric in MBS analysis. Unlike standard bonds, MBS cash flows are uncertain because borrowers can repay early. Yield models use option-adjusted spreads and prepayment assumptions to estimate fair value, which fluctuates as new data reshapes those assumptions—particularly around Fed policy expectations.

Understanding this mechanism helps investors appreciate why MBS yields don’t always parallel Treasury yields. A Fed hike may lift rates but suppress refinancing, tightening spreads in some segments. Market participants monitor Fed communications closely because signal timing drives prepayment behavior and hence pricing dynamics.