Agency mortgage-backed securities offer relatively attractive yields today, without much credit risk.
A modest increase in intermediate- or long-term Treasury yields could lead to lower mortgage-backed securities’ prices, and perhaps more so than the stated duration might imply.
Agency mortgage-backed securities can be considered “core” bond holdings, but they have many unique characteristics that investors should be aware of before investing.
Agency mortgage-backed securities are often a misunderstood investment, but today they offer relatively attractive yields while still maintaining a low level of credit risk. They do have many unique characteristics compared to traditional bonds, so investors should be cognizant of those details before investing.
Mortgage-backed securities: the basics
A mortgage-backed security (MBS) 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, an 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.
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.1 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.
- 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.
Mortgage-backed securities are relatively attractive today
Agency mortgage-backed securities’ yields look attractive relative to U.S. Treasuries and even many investment-grade corporate bonds.
In today’s low-yield environment, relative yields are important. A “spread” is the yield advantage that a non-Treasury security offers relative to a comparable Treasury. Compared to U.S. Treasuries, the average option-adjusted spread of the Bloomberg Barclays U.S. MBS Index is 0.4%, or 40 basis points.2 While that’s only slightly above its 10-year average of 0.37%, it’s near the high-end of its five-year trading range.
Mortgage-backed securities look even more attractive when compared to investment-grade corporate bonds—the difference in spreads for these two investments is the narrowest it has been in more than a decade.
The average spread of the Bloomberg Barclays U.S. Corporate Bond Index fell sharply in 2019 and is close to its lowest point of the last decade. Meanwhile, mortgage-backed securities’ spreads have modestly risen of late. The gap between investment-grade corporate bond spreads and agency MBS spreads is now at its lowest level in more than a decade.
MBS spreads have risen modestly while corporate bond spreads have fallen
Source: Bloomberg, using weekly data as of 1/9/2020.
In a world of low yields and rising risks, agency mortgage-backed securities look relatively attractive compared to investment-grade corporate bonds. The relative yields that corporate bonds offer above Treasuries are roughly 60 basis points more than the relative yields that MBS offer, but the corporate bond index has a growing share of lower-rated issues. More than half of the issues in the investment-grade corporate bond index have “Baa” ratings, the lowest rung of the investment-grade scale. Meanwhile, agency MBS generally share the same credit ratings as the U.S. government, rated “Aaa” by Moody’s and “AA+” by Standard & Poor’s.
Over time, agency mortgage-backed securities can help deliver modestly higher total returns than U.S. Treasuries, with less volatility. While their returns lag those over investment grade corporate bonds over time, the lower volatility can help serve as a diversifier for a balanced portfolio.
Although returns have been modest over the past decade, MBS have been less volatile than other major fixed income asset classes
Source: Schwab Center for Financial Research with data provided by Bloomberg. The chart compares annualized total return and annualized standard deviation from January 2010 through December 2019 of the following indexes: Bloomberg Barclays U.S. Aggregate Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. MBS Index, Bloomberg Barclays U.S. Treasury Index, and the Bloomberg Barclays Municipal Bond Index.
Don’t be fooled by the stated duration
Duration is a measure of interest rate sensitivity—the higher the duration, the more sensitive a security’s price is to changing interest rates. This is important for fixed income investors because a bond’s price and yield have an inverse relationship. If its yield rises, its price falls, and vice versa. A common rule of thumb is that, for a given 1% rise (fall) in its yield, an investment’s price would likely fall (rise) by a magnitude of its duration.
The average duration of the Bloomberg Barclays U.S. Fixed Rate MBS Index is just 3.1 today.3 That’s well below other key indexes, like the Treasury bond index, the investment-grade corporate bond index, and the broad U.S. aggregate bond index.
On the surface, MBS appear to have significantly lower durations than other alternatives
Source: Bloomberg, as of 1/9/2020.
But the average duration of the MBS index can fluctuate significantly due to the level of interest rates. If interest rates fall, homeowners tend to refinance their mortgages, leading to a quicker return of the investor’s principal.
As investors get their money back more quickly due to the faster prepayments, the average duration of the index tends to fall. However, that low duration can mask the true interest rate risk. As this chart illustrates, the average duration of the MBS index dropped from 5.6 in November 2018 all the way down to 2.4 in August 2019 as long-term Treasury yields fell sharply. Using the loose rule of thumb from above, the average duration of the index today might imply a roughly 3% drop in its average price if its yield were to rise by one percentage point, but that might understate the actual price drop if yields did in fact rise.
The average duration of the MBS index can be volatile
Source: Bloomberg, using weekly data as of 1/3/2020.
On the other hand, when interest rates rise, as we expect them to do later this year, homeowners generally don’t refinance their mortgages, and that “extension risk” generally pulls up the average duration of mortgage-backed securities.
When evaluating potential investments, we don’t want investors to get lulled into a false sense of security if they spot a low average duration for mortgage-backed securities, only to be surprised by a sharp drop in prices if yields were to rise.
What to do now
Agency mortgage-backed securities can offer investors relatively attractive yields today without taking much additional credit risk. 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 30% 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.
Finally, we expect the 10-year Treasury yield to rise to the 2.25% to 2.5% area later this year. That would likely lead to modest price declines for agency mortgage-backed securities—a negative development for MBS holders—but it would also present investors who have been waiting on the sidelines an opportunity to invest in higher-yielding securities.
1 Source: GinnieMae.gov
2As of 1/9/2020. 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. One basis point is equal to 1/100th of a percent.
3 As of 1/9/2020
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