Q: What are mortgage-backed securities?
A: Investors of mortgage-backed securities (MBS) own an undivided interest in a pool of mortgages that serves as the underlying asset for the security, and these investors then receive a share of the resulting cash flows. A nationwide network of lenders — such as mortgage bankers, savings-and-loan associations and commercial banks — originates the loans backing the MBS. These lenders submit groups of similar mortgage loans to an issuer for securitization. The issuer converts the loans — or securitizes them — into tradable MBS instruments, which the dealers then sell to institutional and individual investors. The vast majority are issued by Ginnie Mae, Fannie Mae and Freddie Mac.
The presence of risk: Ginnie Mae obligations are backed by the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac have an implied backing, but the market perceives it as an implicit backing given the government’s intervention in 2008 and its continued support. Both interest rate risk and duration risk remain in MBS instruments. U.S government bonds have “positive convexity” — if interest rates rise, bond prices fall, and vice versa. MBS do not experience positive convexity. Instead, the expected maturity of an MBS heavily depends on the level of interest rates.
Example of an MBS at work: Assume an investor purchases a newly issued Ginnie Mae MBS with a coupon of 7 percent and an average duration of seven years (which assumes some underlying mortgages will prepay sooner and some will last longer, depending on how interest rates behave). Next, assume a Treasury bond with seven years left to maturity is yielding 6.5 percent. The MBS investor is thus receiving a risk premium of a half percent. If interest rates fall 1 percent, the average expected life of the 7 percent Ginnie Mae can be expected to shorten, as principal repayments unexpectedly accelerate. This happens as other investors take advantage of lower rates to purchase new homes or refinance existing loans. Now, let’s say rates increase to 9 percent. While the prices of both are expected to fall, the price of the Ginnie Mae is expected to fall even further. The Treasury bond’s maturity is the same, but the expected maturity of the Ginnie Mae increases because higher mortgage rates tend to cause investors to postpone purchasing new homes or refinancing. The longer the maturity, the greater the price volatility for any changes in interest rate levels, so an increase in expected maturity adds risk. The only way MBS investors actually collect the expected risk premium is if rates stay within a relatively narrow band. Otherwise, when rates change, they are holding an investment whose duration is lengthening or shortening, respectively, at the wrong time. This effectively results in a “double whammy” to an overall portfolio. Just when investors need fixed income assets to protect their portfolio, the MBS is falling in value and becoming more risky as its maturity lengthens.
Bottom line: Considering the price, reinvestment risks and correlation to equities, MBS instruments are not preferred options for building a portfolio.
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