Mortgage-backed security yields are up sharply this year. While we believe Treasury yields may be near their peak, mortgage-backed securities (MBS) yields may have more upside—and price downside—as the Federal Reserve continues with its "quantitative tightening" (QT) process.
Mortgage-backed securities (MBS) also have unique characteristics compared to traditional bond investments like U.S. Treasuries, so investors should be aware of how they work before considering them as an investment. Below we discuss this year's rise in yields, how Fed policy may impact the price of MBS, and what investors need to know before investing.
Yields are beginning to look more attractive, but QT poses a risk
Like most fixed income investments this year, MBS yields have risen sharply. That shouldn't come as a surprise, as mortgage rates are up as well—the average 30-year mortgage rate was more than 5.5% on July 22, up from the 3%-to-3.25% range during the second half of 2021.
The average yield of the Bloomberg U.S. MBS Index is now 3.5%, close to its 10-year high of 4.2% reached in late 2018. The average yield of the index did hit a recent high of 4.04% in mid-June when the 10-year Treasury yield hit 3.5%, but it has retreated since then.
Mortgage rates and MBS yields are up sharply this year
Source: Bloomberg, using weekly data as of 7/22/2022.
Bloomberg U.S. MBS Index (LUMSTRUU Index) and Freddie Mac US Mortgage Market Survey 30 Year Homeowner Commitment National (NMCMFUS Index). Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. Past performance is no guarantee of future results.
Yields could rise a bit higher, however. First the spread between mortgage rates and average MBS yields is relatively wide. While MBS yields have risen sharply this year, they haven't risen as much as actual mortgage rates. The gap between the average 30-year mortgage rate (5.5%) and the average yield of the Bloomberg U.S. MBS Index (3.5%) is two percentage points, or 200 basis points. Over the last 10 years, that spread has averaged roughly 125 basis points. Mortgage-backed securities' yields may rise modestly to bring that wide gap back to more historical norms.
Second, spreads relative to Treasuries could rise as the Fed reduces its MBS holdings. Mortgage-backed security yields can be deconstructed into a Treasury yields plus a spread. The spread is compensation for additional risks that MBS have, like prepayment or extension, and the overall uncertain timing of the principal prepayments. The average option-adjusted spread of the MBS index is right near its 10-year average.
MBS spreads are near their 10-year average
Source: Bloomberg, using weekly data as of 7/22/2022.
Bloomberg U.S. MBS Index (LUMSTRUU Index). Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. Past performance is no guarantee of future results.
Since March 2020, as part of its "quantitative easing" process the Federal Reserve purchased more than $1.3 trillion in mortgage-backed securities, bringing its total MBS holdings to $2.7 trillion. Those holdings represent more than 38% of the amount outstanding of the Bloomberg U.S. MBS Index. Now the Fed is allowing maturing securities to roll off the balance sheet, rather than the reinvesting the maturing proceeds into new securities.
Beginning in June 2022, the Fed started allowing up to $17.5 billion worth of MBS to actually mature and roll off the balance sheet; anything above that $17.5 billion cap would be reinvested accordingly. Beginning in September, the monthly cap will rise to $35 billion.
This is the second time the Fed has embarked on "quantitative tightening" and the last time it did it, spreads trended higher. The Fed began to allow MBS to roll off its balance sheet in October 2017, starting with initial monthly caps of $4 billion and ultimately growing to $20 billion. When all was said and done, the amount of MBS on the Fed's balance sheet declined by roughly $400 billion by early 2020. Meanwhile, spreads trended higher.
Spreads trended higher during the last version of quantitative tightening
Source: Bloomberg, using weekly data from 1/31/2017 through 1/31/2020.
Bloomberg U.S. MBS Index (LUMSTRUU Index) and Reserve Balance Wednesday Close Mortgage Backed Securities (FARWMBS Index). Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. Past performance is no guarantee of future results.
We believe spreads may rise higher this time around because the amount of MBS holdings is significantly larger. And the Fed has signaled that it prefers to have an all-Treasury portfolio, and has discussed the possibility that it might resort to outright sales of its MBS securities sometime down the road. It's too early to tell if the Fed will begin to sell its MBS holdings, but the recent rise in mortgage rates means that homeowners are less likely to prepay their mortgages, and that it could take longer than initially expected for the MBS holdings to roll off the balance sheet because the pace of principal payments could slow. Considering how large a buyer the Fed has been over the past two years, that's a large void to fill. If enough buyers don't step up, spreads may need to rise to entice more investors.
Mortgage-backed securities: The basics
A mortgage-backed security is a type of investment that is backed by a pool of underlying mortgages. As homeowners make their monthly mortgage payments, those payments are passed on to holders of mortgage-backed securities. This makes MBS investing a little less straightforward than investing in traditional bonds:
- Monthly payments include both interest and principal. Unlike traditional bonds that generally make semiannual interest payments and then repay the principal amount at maturity, a MBS pays its principal down over time. Consider a monthly mortgage payment for a homeowner—it's usually a combination of both interest and principal.
- Monthly payments may fluctuate. Depending on how quickly homeowners pay down the underlying mortgages, the flow of interest and principal payments to MBS holders may vary.
- Prepayment risk. As interest rates fall, homeowners tend to refinance their mortgages, leading to a quicker pay-down of mortgage-backed securities. This is a risk for investors, as they are receiving their money back at a time when interest rates have fallen, meaning they may have to reinvest the proceeds into lower-yielding investments.
- Extension risk. This is the opposite of prepayment risk. If interest rates rise, homeowners are unlikely to prepay their mortgages. MBS holders would likely receive their principal back later than initially assumed, potentially missing out on the opportunity to invest that principal into higher yielding securities. Given the sharp rise in mortgage rates this year, extension risk is a key risk for MBS holders today.
These nuances are important when considering mortgage-backed securities for a fixed income portfolio, especially for those trying to plan for future liabilities. If you're planning for some sort of future expense, mortgage-backed securities might not be as appropriate as traditional bonds with stated maturity dates.
There are many types of mortgage-backed securities, but here we will focus on those that are guaranteed by government agencies:
- Ginnie Mae, or the Government National Mortgage Association, is a government-owned corporation within the U.S. Department of Housing and Urban Development. As an actual government entity, the principal and interest payments of Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. government.
- Fannie Mae, or the Federal National Mortgage Association, is a federally chartered corporation—subject to government regulation and oversight—but is not government-owned like Ginnie Mae. While generally understood to have the implicit backing of the U.S. government, mortgage-backed securities guaranteed by Fannie Mae are not backed by the full faith and credit of the U.S. government and therefore have increased credit risk compared to Ginnie Mae mortgage-backed securities. For example, Fannie Mae’s guarantee of timely interest and principal payments is predicated on the agency’s financial ability to do so. If it were unable to help with those payments, it only has the implicit backing of the U.S. government, as opposed to the explicit backing that Ginnie Mae mortgage-backed securities have.
- Freddie Mac, or the Federal Home Loan Mortgage Corporation, is also a federally charted corporation. Like Fannie Mae, it's regulated by the government, but its mortgage-backed securities are not backed by the full faith and credit of the U.S. government.
What to consider now
Agency mortgage-backed security yields have risen sharply this year, but so have the yields on most other types of bond investments. While the rise in yields has presented a more attractive potential opportunity for investors today, they could consider waiting for a better entry point. We believe spreads should continue to rise as the Fed continues its QT process, and the yield advantage that MBS offer relative to Treasuries is relatively low, meaning investors aren't compensated very well for the additional risks and overall complexity that comes with MBS investments.
Given their relatively high credit quality, agency mortgage-backed securities should be considered as part of a portfolio's "core" bonds holdings. At Schwab, we suggest investors hold up to 20% of their portfolio in agency mortgage-backed securities, but that allocation can vary depending on factors like your risk tolerance, need for income, or need for predictable value at maturity.
Agency mortgage-backed securities can be owned individually or as part of a mutual fund or exchange-traded fund (ETF). However, there isn't a specific category for mortgage-backed securities; they generally fall under the "Intermediate Government" classification and will usually have a reference to mortgage-backed securities in their name. A good place to start is the ETF Select List or Mutual Fund OneSource Select List.
One consideration for investors considering individual mortgage-backed securities: since the principal payments come in little by little, the principal value of a given MBS tends to gradually decline, as opposed to traditional bond investments that repays the $1,000 par at maturity. Reinvesting the proceeds of maturing MBS principal can be more challenging than when holding traditional individual bonds, because the principal payments come more frequently and because the maturing principal could be in small amounts.
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