Analyzing the Prepayment Risk of Current US Agency Bonds

Building a fixed-income strategy for retirement usually starts with simple math. You buy a bond, you collect a stated interest rate, and you receive your principal back on a specific maturity date. It is a predictable, linear process that allows you to calculate exactly how much cash flow you will generate over the next twenty years. But the moment you introduce US Agency bonds—specifically mortgage-backed securities—into that portfolio, the linear math collapses. You are no longer just dealing with a corporate treasurer or the federal government paying a fixed coupon. You are dealing with the collective, highly unpredictable financial behavior of millions of American homeowners.

Every time a homeowner decides to sell their house, refinance their loan, or pay an extra five hundred dollars toward their principal balance, it alters the cash flow of an agency bond. This dynamic is known as prepayment risk. In 2026, managing this risk requires an entirely different playbook than investors used during the low-rate era of the previous decade. We are currently staring down a steepening yield curve, a stubborn ten-year Treasury yield hovering near 4%, and a national housing market frozen by the “lock-in effect” of people refusing to surrender their old 3% mortgages. Analyzing the prepayment risk of current US agency bonds is not an academic exercise; it is the difference between generating a reliable six percent yield and suffering a massive opportunity cost when your capital is forcibly returned to you at the absolute worst possible time.

Foundations of Agency Debt in Retirement Portfolios

To understand the risk, you have to understand the product. An agency bond is a debt obligation issued by a government-sponsored enterprise or a federal agency. While some of these entities issue standard corporate-style bonds—known as agency debentures—the vast majority of the volume and complexity in this space comes from agency mortgage-backed securities (MBS). Wall Street takes thousands of individual home loans, bundles them together into a single pool, and sells fractional ownership of that pool to investors. As the homeowners make their monthly mortgage payments, the principal and interest flow through the agency and directly into your brokerage account.

Retirees flock to these instruments because they offer a yield premium over standard US Treasury bonds while maintaining an exceptionally high credit rating. You get paid more than you would holding a government bond, but you take on significantly less credit risk than you would holding a corporate bond. The tradeoff for that extra yield, however, is entirely found in the structural uncertainty of the cash flows. The borrower has the power, not the lender.

Defining Government-Sponsored Enterprise Securities

The term "agency bond" is an umbrella that covers three very different entities. Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) are government-sponsored enterprises. They are technically private companies chartered by Congress to provide liquidity to the housing market. They do not originate mortgages. Instead, they buy mortgages from local banks, package them into securities, and guarantee the timely payment of principal and interest to the end investor. If a homeowner in one of their pools defaults, Fannie Mae or Freddie Mac steps in and covers the loss using their own corporate capital.

The market treats Fannie and Freddie debt as if it carries the full backing of the US government, but strictly speaking, it does not. They operate under a federal conservatorship established during the 2008 financial crisis, which provides an implicit guarantee. Investors operate on the assumption that the government will never let these entities fail, which keeps their borrowing costs incredibly low, but the technical distinction remains.

Ginnie Mae vs Fannie Mae and Freddie Mac

Ginnie Mae (Government National Mortgage Association) operates differently. It is a wholly owned government corporation located within the Department of Housing and Urban Development. Ginnie Mae guarantees the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans, primarily Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) mortgages. Because Ginnie Mae is a direct government agency, its securities carry the explicit, full faith and credit guarantee of the United States government, putting them on the exact same credit tier as a Treasury bond.

This difference in guarantee structure creates slight yield variations. Because Ginnie Mae bonds have zero credit risk, they typically yield slightly less than Fannie Mae or Freddie Mac bonds. However, the underlying borrower profiles are different. FHA and VA loans often feature lower down payments and different credit score requirements than the conventional loans bundled by Fannie and Freddie. These demographic differences directly influence how quickly those borrowers prepay their mortgages, making the prepayment risk profile of a Ginnie Mae pool distinctly different from a Fannie Mae pool.

The Allure of Government Guarantees in Fixed Income

The primary appeal of agency MBS in a retirement portfolio is the elimination of default risk. If you buy a bond from an airline and the airline goes bankrupt, you might lose eighty percent of your principal in the restructuring process. If you buy a Ginnie Mae bond and a thousand homeowners in that specific pool go bankrupt and face foreclosure, you do not lose a single penny of your principal. Ginnie Mae absorbs the loss and pays you the par value of those defaulted loans immediately.

But this guarantee is exactly what creates the prepayment problem. When a home is foreclosed, the agency buys that loan out of the pool and hands you the remaining principal balance in cash. From your perspective as an investor, a default looks exactly the same as a voluntary early payoff. In both scenarios, you get your money back faster than you expected. The government guarantee protects your principal, but it offers absolutely zero protection for your yield.

The Mechanics of Prepayment Risk

When you buy an agency MBS, you are effectively acting as the bank for thousands of homeowners. The fundamental problem with acting as a bank is that American mortgages are incredibly consumer-friendly. In most commercial loans or corporate bonds, if the borrower wants to pay the debt off early, they face severe financial penalties. These "make-whole" provisions protect the lender's expected return. The standard American thirty-year fixed-rate residential mortgage has no prepayment penalty. The homeowner can pay off the entire balance on the second day of the loan without paying an extra dime in fees.

This structural reality forces the investor to bear the entire burden of interest rate movements. The homeowner holds a massive financial advantage, and they will ruthlessly exploit it whenever the economic conditions favor them. Understanding the mechanics of prepayment risk requires looking at the mortgage contract through the lens of options pricing.

Understanding the Embedded Call Option

Every single mortgage bundled into an agency MBS contains an embedded call option. By allowing the borrower to pay off the loan at any time, the lender has essentially sold the borrower a call option on the debt. If interest rates drop significantly, the borrower will exercise that option. They will go to a new bank, take out a new mortgage at the lower current rate, and use that cash to pay off the old, high-rate mortgage.

The investor receives a massive influx of principal. Think of it as a tenant who decides to pay their rent five years in advance. It sounds like a fantastic situation until you realize you now have a massive pile of cash sitting in your account, and the only place you can reinvest it is in a market that is paying significantly lower interest rates than the ones you just lost. You sold a high-yielding asset and were forced to buy a low-yielding asset. You did not lose principal, but you suffered a severe, permanent reduction in your future income stream.

How Homeowners Dictate Your Portfolio Yield

The speed at which homeowners exercise this option dictates the actual yield you earn on your investment. When you look at the quote for an agency bond, the broker will provide a Yield-to-Maturity based on an assumed prepayment speed. If the homeowners prepay faster than that assumed speed, your actual realized yield will be lower than the quote. If they prepay slower, your yield will change again.

Furthermore, because the homeowner holds the option, the price appreciation of an agency bond is capped. If general interest rates drop from 6% to 4%, a standard 6% Treasury bond will soar in price because investors will pay a massive premium to secure that high coupon. A 6% agency MBS will hardly rise in price at all. Investors know that the moment rates hit 4%, every homeowner in that 6% pool is going to refinance. Why pay a premium for a bond that is about to be paid off at par value next month? This phenomenon is called negative convexity, and it is the single biggest mathematical handicap of mortgage-backed securities.

Contraction Risk vs Extension Risk

Prepayment risk actually splits into two distinct, opposing threats depending on the direction of interest rates. When interest rates fall, you face contraction risk. The homeowners refinance, the mortgages pay off rapidly, and the duration of your bond contracts. A bond you thought would pay you interest for seven years suddenly pays off in two years. You are flooded with cash right when the reinvestment environment is at its worst.

When interest rates rise, you face the exact opposite problem: extension risk. If a homeowner locked in a 3% mortgage in 2021 and current rates are 6.5%, they are never going to refinance. They will cling to that cheap debt for as long as possible. The prepayment speeds in the pool grind to a halt. The duration of your bond extends aggressively. A bond you expected to pay off in five years might now take twelve years to return your principal. You are trapped holding a low-yielding asset in a high-yield environment, and your capital is tied up so you cannot take advantage of the new, better rates.

The Pain of Early Capital Return in Low-Rate Environments

Contraction risk destroys income generation. Imagine you purchased a premium agency bond priced at 104 (meaning you paid $104 for every $100 of principal) because it carried an exceptionally high coupon rate. You expected to amortize that $4 premium over the next ten years. Six months later, rates plummet, the homeowners refinance en masse, and the agency returns your $100 of principal. You just lost the $4 premium entirely. You suffered a capital loss and a loss of future income simultaneously. Buying premium MBS without carefully modeling prepayment speeds is a highly effective way to destroy wealth in a fixed-income portfolio.

Measuring Risk: The CPR and PSA Models

Because prepayment is the dominant risk factor in agency debt, Wall Street analysts have spent decades building mathematical models to predict human behavior. You cannot manage a bond portfolio effectively if you do not understand the metrics used to quote these securities. When a broker pitches an agency bond, they will describe its expected performance using specific industry benchmarks.

These models attempt to quantify exactly how fast the principal balance of a mortgage pool will decline due to early payoffs. They take raw historical data, factor in current economic variables, and project a smooth curve of expected cash flows.

Decoding the Conditional Prepayment Rate

The most fundamental metric in mortgage analytics is the Conditional Prepayment Rate (CPR). The CPR is an annualized percentage representing the portion of the remaining principal pool that is expected to prepay over the next twelve months. If a pool has a CPR of 10%, it means that 10% of the currently outstanding principal balance is expected to be paid off early over the next year.

To calculate the actual monthly cash flow, analysts convert the CPR into a Single Monthly Mortality (SMM) rate. The formula used by quantitative models looks like this:

$$SMM = 1 - (1 - CPR)^{1/12}$$

If you have a CPR of 12%, the math converts that to an SMM of roughly 1.05%. This means that in any given month, you expect to receive 1.05% of the outstanding principal balance back as an early prepayment, in addition to the regularly scheduled amortization payments. Tracking the historical CPR of a specific pool tells you exactly how aggressive the homeowners are being with their refinancing activity.

The Public Securities Association Benchmark

While the CPR gives you a flat percentage, it ignores the reality of how a mortgage ages. A homeowner who just bought a house last month is highly unlikely to refinance or move next month. Prepayment speeds are naturally very low at the beginning of a loan, ramp up as the loan ages, and eventually level off. To account for this aging curve, the industry uses the Public Securities Association (PSA) standard prepayment model.

The PSA model establishes a baseline curve. A bond quoted at "100% PSA" assumes that the CPR starts at 0.2% in the first month and increases by 0.2% every month for thirty months. By month thirty, the CPR hits 6.0% and remains flat at 6.0% for the remaining life of the loan. This is the baseline.

If an agency bond is quoted at 150% PSA, it means the market expects the pool to prepay 1.5 times faster than the baseline curve. By month thirty, the CPR would be 9.0% instead of 6.0%. If the bond is quoted at 50% PSA, the market expects it to prepay half as fast as the baseline. When comparing two different agency bonds, you must look at the PSA assumption the dealer is using to calculate the yield. If a dealer quotes a massive yield based on an unrealistic 500% PSA assumption, they are manipulating the math to make the bond look better than it actually is.

The 2026 Interest Rate Environment and MBS Pricing

The mathematical models are only as good as the economic inputs you feed them. To accurately assess prepayment risk right now, you have to look at the specific macroeconomic realities of 2026. The extreme volatility we saw during the inflation spikes of 2022 and 2023 has mostly burned off. The Federal Reserve executed a series of aggressive rate hikes, paused, and then delivered rate cuts in late 2024 and 2025. Currently, the market is pricing in a highly stable, albeit elevated, rate environment.

Data from fixed-income analysts in the spring of 2026 indicates that the 10-year Treasury yield is holding firmly near 4%, driven by sticky inflation numbers and massive federal deficit spending. Mortgage rates hit a high of roughly 6.64% early in the year and are expected to bounce in a tight channel between 5.50% and 6.20% through 2027. This specific interest rate band creates a fascinating dynamic for agency MBS.

Navigating the Post-Inflationary Yield Curve

The yield curve, which spent years deeply inverted, has begun to steepen. A steeper yield curve is generally highly constructive for mortgage-backed securities. It improves the carry profile of the asset class, meaning investors get paid a healthier spread to hold longer-duration risk. More importantly, higher term premiums at the long end of the curve tend to stabilize prepayment speeds. When long-term rates remain persistently elevated, it completely removes the threat of a massive, systemic refinancing wave.

The market refers to this as a low-volatility rate environment. Interest rate volatility is the absolute enemy of MBS spreads. When rates swing wildly up and down, the embedded call option held by the homeowner becomes incredibly valuable, which depresses the price of the bond. In 2026, the ICE BofA MOVE Index, which tracks Treasury rate volatility, has normalized significantly. This lower volatility flips the script, turning the macroeconomic environment from a massive headwind into a supportive tailwind for agency debt.

Impact of Mortgage Rate Fluctuations on Agency Spreads

Because the current mortgage rates are bouncing around 6.0%, we have a heavily segmented market. For anyone who took out a mortgage in 2023 at 7.8%, a drop to 5.75% represents a highly attractive refinancing opportunity. If you own pools backed by 2023-vintage loans with high coupons, you are currently experiencing high contraction risk. Those borrowers are actively exercising their call options.

Conversely, if you own pools backed by 2020-vintage loans with 3.0% coupons, you are experiencing massive extension risk. Those borrowers are deeply "out of the money." A drop in current rates from 6.5% to 5.5% means absolutely nothing to a borrower paying 3.0%. They will not refinance. Therefore, your prepayment analysis in 2026 depends entirely on the specific coupon stack you are holding. You cannot treat the agency market as a single, homogenous entity.

Factors Influencing Prepayment Speeds Beyond Rates

While interest rates are the dominant driver of prepayment speeds, they are not the only driver. If you rely entirely on an interest rate model, you will severely miscalculate the actual cash flows of your agency bonds. Homeowners are not purely rational financial actors. They get divorced, they get new jobs across the country, they have children, and they downsize in retirement. All of these life events force a homeowner to sell their property, which triggers a prepayment on the mortgage regardless of where interest rates are currently sitting.

Understanding these demographic and structural factors is what separates institutional fixed-income managers from retail investors who simply chase yield quotes.

The Role of Housing Turnover and Demographics

Housing turnover provides a baseline level of prepayment speed that persists even in high-rate environments. People have to move. However, the current 2026 market is experiencing a severe depression in turnover due to the lock-in effect. According to recent data from modeling firms like RiskSpan, the housing market is seeing highly constrained supply. Homeowners who want to move up to a larger house are refusing to list their current properties because taking on a new mortgage at 6.2% would double their monthly payment compared to their existing 3% loan.

This lack of housing inventory artificially suppresses prepayment speeds across the entire agency market. When the baseline turnover rate drops, the duration of all MBS pools extends. However, models indicate that housing turnover is highly sensitive to the refinancing incentive. During the post-pandemic boom, turnover spiked nearly 50% above baseline levels. As rates slowly trend downward, we expect to see pent-up demand release, which will trigger a sudden spike in base turnover prepayments that catch many fixed-income investors off guard.

Burnout: Why Some Borrowers Never Refinance

One of the most fascinating psychological elements of prepayment risk is the burnout effect. Suppose mortgage rates drop dramatically, providing a massive financial incentive for everyone in a specific 6% MBS pool to refinance. In the first few months, the CPR will skyrocket as the highly attentive, financially savvy borrowers secure new loans.

But after a year of low rates, the prepayment speeds in that specific pool will suddenly plummet, even if rates remain low. The pool has experienced burnout. The only borrowers left in the pool are the ones who are financially illiterate, have terrible credit scores, lack the equity to qualify for a new loan, or simply cannot be bothered to fill out the paperwork. Once a pool burns out, its prepayment speed becomes highly stable and extremely low. Institutional investors pay massive premiums for burned-out pools because they offer high coupon yields with very little contraction risk. The smart money already left the pool, leaving the sticky money behind.

Geographic Variance in Mortgage Behavior

Prepayment risk is also highly localized. A mortgage pool backed entirely by properties in California behaves very differently than a pool backed by properties in Ohio. California historically exhibits much faster prepayment speeds because the property values are massive, meaning a small drop in interest rates translates to a massive monthly dollar savings, heavily incentivizing a refinance. In markets with lower home values, the dollar savings might not cover the closing costs of the new loan, suppressing the refinancing rate.

Furthermore, states with high corporate relocation rates or booming tech sectors see higher housing turnover than states with aging, stagnant populations. When you buy a specific agency pool, you can request a geographical breakdown of the underlying loans. Overweighting states with sluggish turnover provides natural protection against contraction risk during a falling rate environment.

Strategic Asset Allocation: Managing Risk

You cannot eliminate prepayment risk if you want to hold agency MBS. The goal is to manage it, quantify it, and ensure you are being adequately compensated for taking it. Incorporating these assets into a retirement portfolio requires moving beyond simple yield quotes and understanding how different MBS structures react to stress.

Most retail investors access the agency market through broad mutual funds or ETFs. These funds aggregate thousands of different pools, effectively blending the prepayment risks of high-coupon and low-coupon bonds. While this provides diversification, it also guarantees that you will experience both contraction and extension risk simultaneously depending on the macroeconomic shifts.

Yield-to-Worst vs Yield-to-Maturity

When analyzing your fixed-income statements, you must ignore the Yield-to-Maturity figure on an agency bond. That number assumes no homeowner ever prepays their mortgage early over the next thirty years, which is a statistical impossibility. Instead, you must look at the Yield-to-Worst or use a specialized Option-Adjusted Spread (OAS) model.

The Option-Adjusted Spread calculates the yield premium you are earning over a risk-free Treasury bond after mathematically deducting the value of the embedded call option held by the homeowners. If the OAS is wide, the market is heavily discounting the bond due to prepayment fears, and you are being paid a handsome premium to take the risk. If the OAS is tight, you are taking on massive uncertainty for almost no additional yield. In the current 2026 environment, active managers are finding highly attractive relative value in specific agency MBS compared to investment-grade corporate credit by rigorously analyzing these spreads.

The Use of PAC Bonds for Predictable Cash Flow

Wall Street recognized that institutional investors hated prepayment uncertainty. To solve this, they created Collateralized Mortgage Obligations (CMOs). A CMO takes a massive pool of mortgages and slices the cash flows into different tranches, prioritizing the principal payments to create customized risk profiles.

The most important structure for a conservative retirement portfolio is the Planned Amortization Class (PAC) bond. A PAC bond offers a highly predictable schedule of principal payments, operating almost exactly like a standard corporate bond. You know exactly how much cash you will receive every single month, regardless of whether the underlying homeowners prepay their mortgages quickly or slowly.

Planned Amortization Classes vs Companion Tranches

A PAC bond achieves this stability by shifting all the prepayment risk onto a different tranche of the CMO, known as the companion or support tranche. If prepayment speeds suddenly accelerate, the excess cash is dumped entirely into the companion tranche, shielding the PAC bond from contraction risk. If prepayment speeds slow down, the companion tranche is starved of principal, shielding the PAC bond from extension risk.

The PAC bond is protected as long as the actual prepayment speeds stay within a designated PSA collar, such as between 100% and 300% PSA. Because the companion tranche absorbs all the toxic volatility, the companion tranche offers a massive yield, but the price swings wildly. The PAC tranche offers a lower yield, but the cash flow is incredibly stable. For retirees demanding predictable monthly income, trading away a little yield to secure a PAC bond is a highly effective way to neutralize the prepayment risk of the agency market.

Comparing Agency Bonds to Treasury Securities

Every asset allocation decision in fixed income eventually comes back to the risk-free rate. You are constantly comparing the yield of your chosen asset to the yield of a comparable United States Treasury bond. The Treasury bond represents pure, unadulterated duration risk with zero credit risk and zero prepayment risk. The agency bond represents zero credit risk (or near-zero), massive prepayment risk, and complex duration risk.

You have to demand a specific premium to justify taking on the complexity. If the ten-year Treasury is yielding 4.00%, and a Fannie Mae MBS is yielding 4.25%, you are taking on the entire burden of homeowner prepayment behavior for a measly twenty-five basis points of extra yield. That is a terrible trade. You are not being compensated for the negative convexity of the asset.

The Yield Premium Justification

Historically, agency MBS trade at a spread of roughly 40 to 80 basis points above comparable Treasuries. During periods of severe market stress or massive interest rate volatility, that spread can blow out to 150 basis points. The 2026 market shows strong demand from banks and potential regulatory relief on securitization capital, which is keeping MBS spreads relatively healthy but not distressed.

You justify the purchase of an agency bond when the Option-Adjusted Spread compensates you for the expected volatility. When you buy a broad MBS index fund, you are betting that the extra yield you collect every month will outpace the occasional capital losses you suffer when the portfolio contracts or extends against your favor. It is a long-term statistical play, not a short-term tactical trade.

Liquidity Considerations for Retirees

One distinct advantage agency bonds hold over almost every other fixed-income sector outside of Treasuries is liquidity. The US agency MBS market is massive, highly standardized, and relentlessly traded by global central banks, sovereign wealth funds, and massive pension plans. If you need to liquidate a position to fund an emergency medical expense or a large purchase, you can sell an agency bond in seconds with an incredibly tight bid-ask spread.

If you hold municipal bonds or obscure corporate debt, selling during a panic can cost you five percent of your principal just crossing the spread. Agency bonds offer deep, institutional-grade liquidity. You are never trapped in the asset. The price might fluctuate based on rates, but you will always find a buyer immediately.

My Personal Take on Agency Debt

I view agency mortgage-backed securities as a necessary frustration. Early in my career, I bought a premium Ginnie Mae fund purely because it offered a yield that crushed standard Treasuries. I thought I was a genius. Then the Federal Reserve slashed rates, the entire country refinanced their homes, and the fund returned a massive chunk of my capital at a steep loss. The yield evaporated overnight. I learned exactly what negative convexity feels like when it hits your monthly statement.

Since then, I completely changed how I allocate to the space. I refuse to buy premium mortgage pools directly. The downside risk is too severe. If I buy individual MBS, I look strictly for discount bonds—pools that were minted years ago at 3% or 4% and are currently trading well below par. With a discount bond, if the homeowners suddenly decide to prepay, I actually experience a capital gain as the principal is returned to me at par value. It flips the prepayment risk from a threat into a potential catalyst for profit.

For the average retiree, navigating the CPR math, tracking housing turnover data, and calculating PSA curves is an exhausting, full-time job. I highly recommend accessing this market through actively managed mutual funds rather than passive index ETFs. A passive index blindly buys every mortgage pool the agencies issue, exposing you to maximum prepayment volatility. A skilled active manager can deliberately overweight seasoned, burned-out pools, manage the geographic distribution of the loans, and tactically employ PAC bonds to smooth out the cash flows. In the agency market, you get what you pay for, and paying a small management fee to a team of quants who understand prepayment behavior is the smartest fixed-income decision you can make.

Frequently Asked Questions

What is the difference between contraction risk and extension risk?
Contraction risk occurs when interest rates fall, causing homeowners to refinance and pay off their mortgages early. Your capital is returned to you quickly, forcing you to reinvest at lower rates. Extension risk occurs when interest rates rise, stopping homeowners from moving or refinancing. Your capital gets locked up in the low-yielding bond for much longer than you originally anticipated.

Are Ginnie Mae bonds completely risk-free?
They are free of default credit risk because they carry the explicit guarantee of the US government. However, they carry significant interest rate risk and prepayment risk. If you buy a Ginnie Mae bond and rates drop, the underlying mortgages will be paid off early, lowering your expected yield. The government guarantees the return of your principal, not the stability of your yield.

What does a CPR of 15% actually mean?
A Conditional Prepayment Rate of 15% means that analytical models expect fifteen percent of the currently outstanding principal balance in that specific mortgage pool to be paid off early over the next twelve months, in addition to the regular monthly amortization payments.

Why do agency bonds exhibit negative convexity?
When interest rates drop, normal bond prices rise linearly. Agency bonds do not. Because the homeowner has the option to refinance when rates drop, the investor's upside price appreciation is capped. Nobody will pay a massive premium for a bond that is about to be paid off at face value. This capped upside combined with full downside exposure is the definition of negative convexity.

How does the lock-in effect change prepayment models?
The lock-in effect refers to homeowners refusing to sell their homes because they have a historically low mortgage rate (e.g., 3%) and do not want to buy a new house with a current rate of 6.5%. This drastically reduces base housing turnover, which suppresses prepayment speeds across the entire agency market and extends the duration of existing MBS pools.

What is an Option-Adjusted Spread (OAS)?
OAS is a yield metric used to evaluate mortgage-backed securities. It takes the gross yield spread over a risk-free Treasury bond and mathematically subtracts the estimated value of the embedded call option held by the homeowner. It shows you the true, risk-adjusted premium you are earning for holding the agency bond.

Should I hold agency bonds in a rising interest rate environment?
In a rising rate environment, existing agency bonds will suffer price declines and extension risk as prepayments slow to a crawl. However, newly issued agency bonds will carry higher coupon rates. If the yield curve is steep, the higher starting yield can provide an attractive carry, but you must be prepared to hold the asset for a longer duration than originally modeled.

What is a Planned Amortization Class (PAC) bond?
A PAC bond is a specific tranche within a Collateralized Mortgage Obligation. It provides a highly predictable, fixed schedule of principal payments, shielding the investor from both contraction and extension risk. The volatility is absorbed by a different tranche in the structure known as the companion bond.

Legal Disclaimer: The information provided in this article is for educational and informational purposes only and does not constitute financial, investment, or tax advice. Mortgage-backed securities and agency bonds carry specific risks, including interest rate risk, prepayment risk, and extension risk. Past performance is not indicative of future results. Always consult with a certified financial planner or registered investment advisor before making decisions regarding fixed-income asset allocation in your retirement portfolio.