Interest risk and prepayment risk

CFA Level II Fixed Income
#1

Ok guys, I tend to get confused when there’s interest rate risk and prepayment risk in the same question. Doesn’t interest rate risk cause prepayment risk? So if the question is like the one below, how should I analyze it?

How I analyzed the below question: because nonamortized debt would react to changing interest rate so much, so the prepayment wouldn’t be a big issue.

Camby is excited about a new ABS issued by a large retailer, Glendo’s. The ABS reflects a bundle of nonamortizing consumer credit accounts. As usual, Price prefers a different option, in this case a new collateralized mortgage obligation (CMO) issued by Trident Mortgage. Both securities offer similar total return potential and seem reasonably valued. Both Camby and Price believe the other analyst’s preferred securities are too risky.

Camby’s preference for Glendo’s bonds suggests he is most likely concerned about: A) credit risk. B) interest-rate risk. C) prepayment risk. Your answer: B was incorrect. The correct answer was C) prepayment risk. We have little information about the Glendo’s and Trident bonds. All we know is that the Glendo’s ABS is backed by consumer credit accounts, while the Trident securities are backed by mortgage loans. Most consumer-credit accounts are nonrevolving, meaning that during the lockout period, any prepayments will be invested in new loans. As such, the Glendo’s ABS probably has less prepayment risk than the Trident ABS. We don’t know enough about the loans to conclude anything about their credit or interest-rate risk. But the difference in prepayment risk is apparent. Camby’s preference for Glendo’s suggest he wants to avoid prepayment risk. (Study Session 13, LOS 40.b)

#2

If you have a prepayable bond with a coupon of 6%, then when interest rates are at 10% there is interest rate risk, but virtually no prepayment risk.

Both interest rate risk and prepayment risk respond to changes in interest rates, but neither one causes the other; they’re both caused by other factors: level and volatility of interest rates.

The way you should analyze this question is to note that both credit card ABSs and CMOs have credit risk, and both have interest-rate risk, but because credit card ABSs have a lockout period while CMOs don’t, the ABS initially has no prepayment risk, but the CMO has prepayment risk.

#3

Ok should I automatically assume nonamortized asset backed ABS has no prepayment risk? I’m always haunted by the part which says “if nonamortized asset back ABS performs under the bench mark, it can be called by investors”

#4

If the investors call it, that’s not prepayment risk; that’s an option they own and they exercise, not an option that’s being exercised against them.

#5

So what exactly is the prepayment risk for non amorortized asset ABS investor when the underlying non asset back ABS underperform? Are these investors “forced” to take back their investment?