Constant-Duration Mortgage Index

Abstract

The authors introduce an MBS index dynamically rebalanced to a desired duration target. It can serve as a performance benchmark for MBS portfolios that are delta-hedged against fixed liabilities or duration targets. It can also be used to compare returns on mortgages to returns on Treasuries with the same duration. Performance results show that the return advantage in a stable yield environment more than compensates for the adverse effect of negative convexity in trending and volatile periods. Historical simulation over 1994-1998 shows that the dynamic MBS strategy targeting the duration of the Lehman Brothers Treasury Index retains most of the mortgage-backed securities' return advantage, with a tracking error comparable to the historical volatility of excess return for other spread products.