Understanding Weighted Average Coupon (WAC) for Mortgage-Backed Securities

What is Weighted Average Coupon (WAC)?

The Weighted Average Coupon (WAC) represents the average interest rate of the mortgages underlying a mortgage-backed security (MBS), calculated by weighting each mortgage's coupon rate by its principal balance at issuance. This metric helps you evaluate the overall yield and interest rate profile of a mortgage pool, crucial for pricing and risk management.

Understanding WAC is essential when analyzing mortgage securities alongside related concepts such as WACC and portfolio interest rates.

Key Characteristics

WAC is defined by several important features that influence its role in mortgage-backed securities:

• Balance-Weighted Rate: It weights each mortgage coupon by its outstanding principal, reflecting the pool's average yield.
• Calculated at Issuance: Typically measured using original balances, though it evolves with prepayments.
• Indicator of Yield and Risk: A higher WAC often signals greater yield but also increased prepayment risk.
• Related Metrics: Complements the Macaulay Duration by focusing on interest rates rather than timing.
• Used in Agency MBS: For example, AGNC relies on WAC to assess portfolio yield and performance.

How It Works

To calculate WAC, multiply each mortgage’s coupon rate by its principal balance, sum these products, and divide by the total principal balance. This yields a weighted average that accurately reflects the pool’s overall interest rate.

Since mortgage pools experience prepayments and defaults, the WAC can shift over time, affecting valuation and cash flow projections. Investors often compare WAC against the pass-through rate, which deducts servicing fees, to understand net returns.

Examples and Use Cases

WAC is widely applied in mortgage-backed securities analysis and portfolio management. Here are practical examples:

• Mortgage Pools: A pool with $6 million at 7.5% and $4 million at 5% has a WAC of 6.5%, showing how larger higher-rate loans influence the average.
• Agency MBS Investors: AGNC uses WAC to evaluate its asset yields and hedge interest rate exposure.
• Bond Funds: Fixed income funds like those tracking BND consider WAC when assessing mortgage-backed securities within their portfolios.

Important Considerations

While WAC provides a snapshot of average coupon rates, it does not capture changes in prepayment speeds or credit risk, which can alter actual cash flows. You should complement WAC analysis with metrics like duration or prepayment models to get a full risk profile.

Also, WAC assumes a static pool at issuance; active management and market conditions will influence the weighted average coupon over time, impacting your investment returns.