4 Reasons to Invest in Mortgage-Backed Securities

By Henry Song, CFA and Douglas Gimple
June 2019

Mortgage-backed securities (MBS) can play an important role as a fixed income asset class that offers several benefits. In addition to historically attractive yields compared with Treasuries and low volatility, these highly liquid assets provide diversification, which can lower portfolio risk.

Many fixed income investment managers, including Diamond Hill, make significant allocations to agency and non-agency MBS for the variety of benefits they offer.

1. Historically attractive yields relative to Treasuries.
Agency MBS may improve the risk-return profile of fixed income portfolios, as they are similar in credit quality to Treasuries but with a higher historical yield. Over the last 10 years, MBS yields have averaged 2.53% over Treasury bills (see Figure 1 below).

FIGURE 1: COMPARATIVE YIELDS: MORTGAGE-BACKED SECURITIES VS. TREASURIES

COMPARATIVE YIELDS: MORTGAGE-BACKED SECURITIES VS. TREASURIES

Source: Bloomberg Barclays Live.

2. Generally high risk-adjusted returns.
MBS have historically experienced low volatility compared to other fixed income asset classes, while the Sharpe ratio has been historically high compared to most other fixed income asset classes (see Figure 2 below).

FIGURE 2: 10-YEAR STANDARD DEVIATION & SHARPE RATIO

10-YEAR STANDARD DEVIATION & SHARPE RATIO

Source: Morningstar Direct. As of 3/31/19.

3. Diversification due to low correlation to other asset classes.
Since their returns move inversely to other fixed income asset classes, MBS may also serve to lower the risk of portfolios. For most fixed income securities, as interest rates rise, prices decline, and as interest rates fall, prices increase. However, borrowers’ prepayments, and changes in the level and speed of repayment, can affect MBS valuation. The prices of agency MBS tend to rise as interest rates rise, when prepayment levels are low, and decline when interest rates drop and prepayments are higher. Agency MBS also have a lower correlation to equity returns than most other fixed income asset classes.

4. The liquidity of the market.
The agency MBS market is large and highly liquid, with $7.3 trillion in assets outstanding and an average daily trading volume of $270 billion (Source: Securities Industry and Financial Markets Association. As of March 31, 2019). This liquidity makes it relatively easy for buyers to find sellers and vice versa, and transaction costs tend to be lower.

Learn More about Diamond Hill Fixed Income
Through a rigorous research-based bottom-up approach, Diamond Hill delivers unique fixed income solutions to clients, providing diversification while managing downside risk.

For more information, call 855.255.8955.

Key definitions: Agency MBS are issued or guaranteed by an agency of the U.S. government such as Ginnie Mae, or by government sponsored-enterprise (GSEs), including Fannie Mae and Freddie Mac. Non-Agency MBS are issued by private firms, such as subsidiaries of investment banks, financial institutions, and homebuilders. Sharpe Ratio uses a strategy’s standard deviation and average excess return over the risk-free rate to determine reward per unit of risk. Standard Deviation measures the volatility of a strategy’s returns.

This material is for educational purposes. The views expressed are those of Diamond Hill Capital Management as of June 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk including the possible loss of principal.

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