IFC practice question 8 of 35

What best describes why mortgage funds generally have less sensitivity to changes in interest rates than bond funds?

Answer options

A: Many mortgage funds also hold T-bills and mortgage-backed securities, which are less volatile

B: Interest on mortgages is usually paid monthly, while interest on bonds is typically paid semi- annually Correct answer

C: Mortgage funds are highly diversified, often holding over 10,000 individual mortgages

D: Most mortgages held in mortgage funds are either NHA-insured or privately insured

Correct Answer:

B. Interest on mortgages is usually paid monthly, while interest on bonds is typically paid semi- annually

Explanation

Mortgage funds have lower interest rate sensitivity primarily because of the structure of mortgage payments. Mortgages require monthly payments of both principal and interest. This regular return of principal shortens the fund's weighted-average term to maturity, also known as duration. A shorter duration means the fund's value is less sensitive to fluctuations in interest rates compared to a bond fund, where principal is typically repaid in a lump sum at maturity.

Why Incorrect

A. While some funds may hold these securities, the fundamental reason for lower sensitivity lies in the cash flow structure of the core mortgage assets.
C. Diversification reduces specific (unsystematic) risk related to individual defaults, not systematic interest rate risk that affects the entire market.
D. Mortgage insurance protects against credit risk (default risk), not interest rate risk, which is the risk of value change due to interest rate movements.

References

1. Canadian Securities Institute. (2023). Investment Funds in Canada Course Textbook. Chapter 5: Types of Investment Funds, Section "Mortgage Funds".

2. Fabozzi, F. J. (2015). The Handbook of Fixed Income Securities (9th ed.). McGraw-Hill Education. Chapter 25: Mortgage-Backed Securities.

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