Benefits of Investing in Mortgage-Backed Securities
June 25, 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 to Treasuries and low volatility, these highly liquid assets provide diversification, which can lower portfolio risk. While MBS have historically been viewed by some as risky, stricter lending standards were put in place post-Financial Crisis to make the market safer.
Today, the MBS market continues to evolve as new types of securities are created to meet increasingly specific client needs, causing market complexities and nuances that skilled, active portfolio managers can leverage to generate alpha.
Why Invest in MBS?
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
Source: Bloomberg Barclays Live.
2. Generally high risk-adjusted returns.
MBS have historically experienced low volatility compared to other fixed income asset classes (see Figure 2), while the Sharpe ratio has been historically high compared to most other fixed income asset classes.
FIGURE 2: 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. As seen in Figure 3 below, 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.
FIGURE 3: CORRELATION WITH S&P 500 RETURNS
Source: Morningstar Direct. As of 3/31/19.
There are two basic categories of MBS: pass-through securities and collateralized mortgage obligations (CMOs), with pass-through securities being the most common. They employ a structure through which a pool of mortgages flows to a mortgage servicer who collects a fee then passes along principal and interest payment streams to investors on a pro-rata basis. CMOs use a more complex tranche structure, in which a dealer purchases a pool of mortgages and dissects them into various cash flow streams with different time horizons and risk return profiles.
When it comes to the MBS market, active, skilled portfolio managers can generate alpha for their clients.
|TYPE OF MBS||DESCRIPTION||BENEFITS|
|To Be Announced (TBAs)||Seller agrees on a sale price without specifying
which individual mortgages will be agreed upon on
date of settlement.
|The most liquid market in mortgages (combines a
variety of different pools into a standard format).
|Specified Pools||Securities associated with specific mortgage pools.||Allow for more granular detail on the underlying mortgages and the opportunity to focus on specific attributes of the mortgage loan.|
|Planned Amortization Class (PAC) Bonds||Specified principal payment schedule, given priority for principal paydowns over other bonds in the pool.||Designed to have a better-defined weighted average life profile if prepayments and extensions remain within a preordained range.|
|Sequential||Tranches are established in a specific order with a single tranche receiving all principal payments before all other tranches until it is paid off in full.||Creates a series of bonds that range in maturity to meet specific investor needs and allows insurer to meet different maturity requirements.|
|Principal Only/ Interest Only||Focus solely on the principal and interest cash flows from a pool of mortgages.||Allows investors to take advantage of different prepayment and interest rate scenarios.|
|Target Amortization Class (TAC) Bonds||Similar to PAC bonds, with schedule determined using prepayment speed assumptions.||Provide protection from increasing prepayment speeds. Reverse TACs provide protection from a slowdown in speeds (extension).|
|Floater||Coupon resets on a regular basis (usually monthly) following a specific index plus a spread, often subject to cap and floor.||Used to hedge interest rate risk.|
|Inverse Floater||Similar to Floater, but with coupon that moves in the opposite direction of predetermined index.||Used to hedge against reinvestment risk.|
Our Unique Approach to MBS
Diamond Hill is an active manager focused on identifying the mortgage-backed securities that represent the best opportunities in the market, regardless of their weight in the benchmark. Our focus on bottom-up security selection and strict capacity discipline enhance our ability to exploit inefficiencies in fixed income markets.
Our approach to investing in MBS has historically led to a significant overweight to CMOs, which can mitigate prepayment, extension and convexity risk, when compared to the traditional MBS held by the benchmark. Additionally, strict capacity discipline enhances our ability to exploit inefficiencies and outperform in the mortgage market.
All MBS are susceptible to prepayment, extension, and convexity risk. CMOs can mitigate some of this risk, as their cash flow structures differ greatly from traditional mortgage-backed pass-throughs.
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.