APR (Annual Percentage Rate): The annual interest rate on a loan, including any additional fees or charges.
Collateral: Property or assets that are pledged as security for a loan.
Convexity: Technically speaking, a bond’s convexity is the rate of change of its duration. It is measured as the second derivative of the bond’s price with respect to its yield.
Speaking in more plain language, convexity demonstrates how the duration of a bond changes as the interest rate changes. Typically, when interest rates decrease, a bond’s price increases. However, for bonds that have negative convexity, prices decrease as interest rates fall.
Because mortgage borrowers have the option to prepay their loans, many choose to do so when rates decline. This negative bond pricing impact of prepayments often overpowers the positive pricing impact of declining rates. If a bond pays off early, investors will not receive the future benefit of above market rate cash flows. Most mortgage backed securities are negatively convex, and callable bonds usually exhibit negative convexity when market rates decline.
Credit score: A numerical score used to represent an individual’s creditworthiness. It is based on factors such as credit history, payment history, and outstanding debt.
CPR (Constant Prepayment Rate): Aa measure of the rate at which borrowers prepay their mortgages. It is expressed as a percentage of the total outstanding balance of the loans in the portfolio and is typically measured on a monthly basis. CPR is a constant rate, meaning it does not take into account any changes in interest rates or other market conditions.
DTI (Debt-to-Income) ratio: The ratio of a borrower’s monthly debt payments to their monthly gross income.
Default: The failure to make payments on a loan or other financial obligation as agreed.
Delinquency: The failure to make payments on a loan or other financial obligation in a timely manner.
Duration: Duration has two meanings. It can measure the number of years it takes for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates.
A bond’s duration is sometimes confused with its term-to-maturity as certain types of duration measurements are also calculated in years. However, a bond’s term-to-maturity is a linear measure of the years until principal repayment is due; it remains the same regardless of changes in interest rates. Duration, however, is a nonlinear measure, and accelerates as the time to maturity lessens.
Effective Duration: A duration calculation for bonds that have embedded options. Effective duration takes into account that expected cash flows fluctuate as interest rates change and are, therefore, a measure of risk.
Foreclosure: The legal process by which a lender reclaims a property from a borrower who has defaulted on their mortgage.
Interest rate: The percentage of a loan’s unpaid balance that is charged as interest.
LTV (Loan-to-Value) ratio: The ratio of the loan amount to the value of the property used as collateral.
Mortgage-backed securities (MBS): Financial instruments that are backed by a pool of residential mortgages. Investors in MBS receive regular payments from the cash flow generated by the underlying mortgages.
Par: The face value of a bond, preferred stock or other debt instrument. Par value stays static, even as the price of the security may vary with interest rates, credit ratings, and time to maturity.
Prepayment: The early repayment of a loan, often by refinancing or selling the property.
Residential mortgages: A type of loan used to finance the purchase of a single-family home or other residential property.
Servicing: The management of a mortgage loan, including the collection of payments, the handling of delinquencies and defaults, and the foreclosure process.
Underwriting: The process of evaluating a loan application to determine the risk of default and the appropriate interest rate.