Question

A wealthy retired investor is interested in buying Agency mortgage backed securities collateralized by 30-yr mortgages as an investment that will give additional retirement income. When discussing this with the client, you should advise him that if market interest rates fall:__________
A) Principal will be repaid earlier than anticipated and will need to be reinvested at lower rates, generating a lower level of income
B) There may be a loss of principal because homeowners are likely to default on their mortgage loans at higher rates
C) The maturity of the security is likely to extend & principal will be returned to the customer at a slower rate than anticipated
D) He will be able to sell the mortgage backed securities at a large profit because of their long maturity

Answer 1

Answer:

A) Principal will be repaid earlier than anticipated and will need to be reinvested at lower rates, generating a lower level of income

Explanation:

Because of the lower interest rates, the investor will get his principal back faster. This can now be invested back at the new lower rate.

The loan duration will also reduce in this instance.

Getting quick funds to pay off the old higher interest mortgage will be a smart move. There will now be an investment in the lower interest mortgage.