Any security — stock, bond, or otherwise — has a specific risk associated with it. Based on that risk, an investor decides whether or not the price is worth paying. If the security is a “good value”, an investor will buy it. If not, the investor will pass.
Until recently, mortgage bonds were considered a good value because the risk of the investment was relatively low compared to the reward (i.e. interest rate).
If you’re wondering why markets are in disarray right now, it’s because the risk tagged to the mortgage bonds was dramatically underestimated.
Hindsight, as they say, is 20/20.
When homeowners began defaulting on home loans at a quicker pace than was expected, the risk attached to each mortgage bond increased. Higher risk should mean higher return, but investor doesn’t have the right to change a homeowner’s mortgage rate.
As a result, the “reward” on mortgage bonds moved below the risk on which they were originally priced. The bonds, therefore, are a losing bet and the investors either (a) tries to sell the bond at a lower price, or (b) holds the less valuable bond and hopes for a rebound.
The bigger problem in the markets is that — at least so far — the financial models used to determine mortgage “risk” were proven wrong. Until new models are tested and “approved”, markets will continue to literally guess what a mortgage bond should be worth.
This is the major reason why markets have gyrated wildly in August. Investors have no idea what the true value of their mortgage bond investments is/will be.
