Understanding Mortgage-Backed Securities Investing

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, because:

• 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 mortgage-backed security pays its principal down over time. Consider a monthly mortgage payment for a homeowner—it's usually a combination of both interest and principal. As time passes, the original principal value of your investment will decline because that principal is slowly being returned to you.
• 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. Today, prepayment risk seems relatively low because so many homeowners locked in historically low interest rates, so it would likely take a large drop in mortgage rates to make it economically advantageous for many homeowners to refinance and pay off their original mortgages. There are other drivers of prepayment, of course, like relocation for a new job.
• 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.

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 a few types of mortgage-backed securities 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 explicit backing that Ginnie Mae mortgage-backed securities have.
• Freddie Mac, or the Federal Home Loan Mortgage Corporation, is also a federally chartered 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.

Average MBS yields have traded in a range for the past three years. It's off its recent high of 6%, but the 5.2% average yield of the Bloomberg US MBS Index is still at the high end of its 15-year trading range.

Mortgages often start with 30-year terms, but it usually doesn't take all 30 years to get the investment back because most monthly payments include both interest and principal. Mortgage prepayments can accelerate the principal paydown of a mortgage-backed security, as well.

While not an apples-to-apples comparison, average yields on MBS are often considered relative to the 10-year Treasury yield. Over the past 15 years, the Bloomberg US MBS Index offered an average yield advantage of roughly 58 basis points (or 0.58%) over the 10-year Treasury yield. The yield advantage is a little bit higher today, at 68 basis points.

MBS relative yields appear attractive compared to other types of fixed income investments these days. The yield advantage that non-Treasury investments offer above a comparable Treasury is called the "spread." It is usually meant to compensate for additional risks, like credit risk—that is, the risk that the bond issuer will be unable to make interest payments or repay principal. With agency mortgage-backed securities, which generally make up the Bloomberg US MBS Index, credit risk is very low because the securities have either the explicit or implicit backing of the U.S. government. With MBS, the risk is less about whether you will get your money back but when you will get your money back.

The chart below highlights how the current option-adjusted spread (OAS) of each index stacks up compared to its OAS over the past 15 years. For example, investment-grade and high-yield bond spreads have only been this low or lower roughly 10% of the time, but that's not the case with MBS, where spreads sit right near the middle of the 15-year range. Half the time they've been higher, half the time they've been lower.

Keep in mind that MBS spreads tend to trade in a relatively tight range when you exclude the surge from the early weeks of the COVID-19 pandemic in 2020. Spreads currently near their long-term averages make MBS relatively attractive when you consider that investment-grade and high-yield spreads have rarely been as low as they are today.

Investors should be cognizant of the difference between the average yield-to-worst of an MBS and the income stream. The yield-to-worst of an MBS takes into account the income earned plus price appreciation or depreciation. The coupon rates on many MBS are well below the stated yield-to-worst.

In 2020 and 2021, many homeowners purchased or refinanced their homes with historically low mortgage rates. As mortgage rates rose, mortgage activity slowed significantly. As a result, most mortgages that are outstanding today have very low fixed rates—more than two-thirds of the securities in the Bloomberg US MBS Index have coupon rate of 4% or less. The coupon payments make up less than the 5.2% average yield-to-worst, with price appreciation expected to make up the rest over time.

Agency mortgage-backed security yields are still at the high end of their 15-year trading range, and their spreads are more in line with their historical averages compared to many other types of investments. With yields above 5%, investors that may have been focusing on short-term investments like Treasury bills may earn higher yields in MBS, while still helping limit reinvestment risk if the Federal Reserve cuts rates down the road.

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: Reinvesting the proceeds of maturing MBS principal can be more challenging than when holding traditional individual bonds. With MBS, the principal payments come in little by little, so the principal value tends to gradually decline, as opposed to traditional bond investments that repay the $1,000 par at maturity.