Mortgage-backed securities: The investor appeal

Mortgage-backed securities (MBS) basics

MBS possess distinct characteristics that set them apart from other fixed income markets, such as investment-grade corporates or Treasuries. One important distinction is the type of balance sheet they provide exposure to.

There are four types of balance sheets that fixed income investors must assess in an economy:

1. Government balance sheets: Government debt is issued for specific purposes, and credit ratings are available from major rating agencies.
2. Corporate balance sheets
   • Non-financials: Corporations that create gross domestic product (GDP) and can default for various reasons.
   • Financials: Corporations that do not create GDP but help fund it. Financial balance sheets are generally more regulated than non-financials.
3. Consumer balance sheets: These reflect consumers’ debt, savings and wealth.

MBS is the largest market that provides access to the consumer balance sheet. When an individual in the United States seeks to purchase a house, they typically secure a loan from an originator. For instance, if the house costs US$500,000, the individual usually puts up 20% of the cost as a down payment, amounting to US$100,000, with the remaining US$400,000 constituting the loan.

The mortgage originator will examine that individual’s credit, and if the loan is approved, it may be bundled with similar loans to create a security. This process, known as securitization, involves packaging a pool of loans with common characteristics into a trust and selling the resulting set of cash flows to investors. Securitization can encompass various types of debt, including credit card debt and automotive debt as well as mortgages—which are the focus of this discussion.

Securitization, particularly of mortgage-backed securities, is crucial as it reduces the overall cost of loans to consumers by creating a secondary market. When loans that conform to certain requirements are made, the mortgage originators have the option to sell them to one of three agencies: Fannie Mae, Freddie Mac or Ginnie Mae. These entities guarantee the cash flows of the mortgages. Fannie Mae and Freddie Mac offer a quasi-government guarantee, while Ginnie Mae provides a full faith and credit guarantee. In the marketplace, these agency mortgage-backed securities are generally considered fungible.

Key appeals of agency mortgage-backed securities

1. Market size and liquidity: Agency mortgage-backed securities represent the second-largest US fixed income market, with approximately US$8 trillion outstanding, second only to US Treasuries¹. The market is highly liquid, allowing investors to buy or sell billions of dollars in mortgages without significantly impacting the market.
2. Credit quality: These securities come with either an implicit or explicit guarantee backed by the full faith and credit of the US Treasury.
3. Income potential: Investors earn a spread over the risk-free rate (typically the 10-year Treasury), resulting in a slightly higher yield than similar-duration US Treasuries.
4. Diversification: Agency MBS typically have a lower correlation with other market sectors, such as high-yield credit or emerging market debt, providing diversification for an overall portfolio.
    

Risks: prepayment, interest-rate and default

Let’s dive a little deeper into the risks. If agency MBS are guaranteed, then one might wonder why an investor earns a spread over Treasuries—which are considered the “risk-free” rate.

Prepayment risk: Recall our US$500,000 loan example, where our home buyer made a 20% downpayment. Most likely they would have obtained a fixed-rate loan, so let’s say the loan in this example had an interest rate of 6%. If market interest rates start to decline after the borrower secured the 6% mortgage rate, that individual has the ability to prepay that mortgage; meaning, they can refinance it and lock in a new, lower rate—and thus, have lower monthly loan payments going forward. This is prepayment risk for the mortgage investor.

Interest-rate fluctuations: Declining interest rates are generally unfavorable for the MBS market. For example, during 2020-2021, historically low mortgage rates (around 3%) led to a significant refinancing wave. Conversely, higher interest rates reduce the incentive for homeowners to refinance. In 2023-2024, interest rates rebounded, so homeowners with lower rates from years prior had no incentive to refinance their mortgages. These fluctuations create uncertainty for the investor.

Default Risk: While corporations, consumers and governments may default on debt, the US government guarantee on mortgages mitigates this risk for MBS to a degree. Corporations, consumers and even governments do at times default on debt. However, in the securitized markets, hard assets back the investment, providing additional security. The consequence is that loans on houses or loans on automobiles or other assets may still have value if an individual were to default.

Non-agency MBS and other investor considerations

When loans are grouped together, they must meet the agency’s underwriting criteria to become part of a mortgage-backed security that’s guaranteed. If they don’t meet the criteria, that loan is not eligible to be included within an agency mortgage-backed security pool. However, there is another market, the non-agency MBS market, that these might fall into.

Within fixed income, 80% of an investor’s return is tied to interest rates—and we already mentioned prepayment risk that is associated with MBS when interest rates decline. As such, there is some cash flow uncertainty—the investor may not be able to perfectly forecast the timing of the anticipated cash flow.

Let’s look at the flipside of re-financing risk—and how it can benefit the investor. If my assets are trading at a discount and I get everything back at par, that's a benefit to me. If they are trading at a premium, it's not. The fact that interest rates can move in either direction, and my investment can move between premium and discount. There’s uncertainty—but also opportunity.

As mentioned, the agency mortgage-backed securities market is also highly liquid. The non-agency MBS market is not as liquid, so as an investor, there is a “liquidity premium” wherein you are taking more risk and thus will be compensated higher accordingly.

So as investors in this space, we look through the lens of each of these types of risk and the risk premium provided. What’s the spread? What is the value to the overall portfolio? Can I hedge any of the risk? Agency MBS carry two of the aforementioned risks: interest-rate risk and cash flow timing uncertainty. Non-agency MBS also carries liquidity risk and default risk.

Market outlook

As the yield curve transitions from inverted to positively sloped, bank demand for MBS is likely to increase. Banks, the largest investors in agency MBS, have low risk-based capital requirements due to government guarantees. International investor demand could also rise if the US dollar declines, making hedge-adjusted interest carry more attractive.

In addition, the Federal Reserve owns about a quarter of the MBS market and has not stated any plans to sell, so those assets are locked up. Somewhat limited supply and higher demand should translate into tighter spreads over the medium term. While declining interest rates are detrimental to some types of fixed income (given the aforementioned prepayment risk) most of the mortgage universe today (roughly 70%) is in 3.5% coupons or lower² so mortgage rates would need to decline by 200 to 300 basis points before prepayment risk ignites in mortgage-backed securities.

The consumer looks quite healthy right now, which we believe also bodes well for this market in the year ahead; mortgage credit appears to be the healthiest it has been in the last 30 or 40 years, meaning that borrower credit scores tend to be high, the loan-to-value ratios on the properties tend to be low, and debt service coverage ratios are also very high. The mortgage borrower today has a massive amount of wealth sitting on their balance sheet.

Navigating market complexities

The MBS market is complex, with a pool of diversified borrowers and various security structures. This complexity can deter some investors but also creates opportunities for those with the expertise to navigate it. Our team is dedicated to understanding the assets, borrowers and creditworthiness, projecting prepayments and defaults to determine the best risk premium for the lowest risk. That's essentially the “Holy Grail” for us as investors—determining what assets offer the best risk premium for the lowest amount of risk, no matter what the rating agencies might say about a particular asset.

In summary, MBS offer unique characteristics and opportunities for investors, including high liquidity, income potential and diversification, while also presenting specific risks that must be carefully managed.