Cash Flow Yield, Nominal Spread, and Zero Volatility Spread for ABS/MBS

Cash Flow Yield

Unlike bonds, cash flows for MBS/ABS investments are commonly monthly.  The cash flows will be made up of interest, scheduled principal repayments, and principal prepayments.  In order for the cash flow expectations to approximate reality, prepayment assumptions must be made.

r bond equiv. yield = 2[(1 + i monthly)6 – 1]

An investor actually realizing the cash flow yield return depends upon the following taking place:

  • Cash flows are re-invested every month at the cash flow yield;
  • Prepayments equal the assumed prepayment schedule;
  • The investor holds the ABS/MBS until it is retired.

Nominal Spread

Compares the cash flow yield of the ABS/MBS to the yield to maturity of a Treasury security with a maturity equal to the average life of the ABS/MBS.

Nominal Spread = CF Yield – YTM of comparable Treasury

The nominal spread may be a flawed measure of comparison as the spread may not reflect risk premiums unique to the ABS/MBS, such as prepayment risk.

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