Cash flow yield on MBS/ABS

[jsshuai158]

I understand that CFY factors in prepament rates. So how does CFY yield change with respect to changes prepayment rates? This gets more complicated as the CFY is equal to the yield that balances the price of the bond and the future cash flows (accounted for prepayment), but how does the CFY compare to YTM? is it more or less than the YTM? My initial thought is that it’d be more than YTM as the short term cash flows weights increases more than the long term cash flow weights. Can someone please provide some insight to this concept please?
thanks!

 

[S2000magician]

I did some quick calculations.
Suppose that you have a $100,000, 10-year, 5% coupon, monthly-pay, fully amortizing bond.
At a YTM of 6%, the value is $95,537 if there are no prepayments.
Suppose that prepayments are $100/month, then to get the same value the CFY would be 6.1099%.
At a YTM of 4%, the value is $104,761 if there are no prepayments.
Suppose that prepayments are $100/month, then to get the same value the CFY would be 3.8898%.
Thus, you cannot generalize that the CFY will always be higher or lower than the YTM.

 

[jsshuai158]

Thanks, Magician. What if we keep the YTM constant at 6%, and increase/decrease the prepayment rate, what would happen to the CFY? My expectation would be that CFY will increase as prepayment increase and vice versa. would that be correct?

 

[S2000magician]

Using the same bond above, if prepayments are $200/month, and YTM is 6%, CFY is 6.2193%. As expected, the higher the prepayment, the higher the CFY. (Makes sense: it went up when prepayments changed from $0 to $100, so we’d expect it to go up when prepayments change from $100 to $200.)