Understanding MBS Market Complexities Can Generate Alpha

By Henry Song, CFA and Douglas Gimple
June 2019

Since the issuance of the first mortgage passthrough securities in the 1970s and 1980s, the mortgage-backed securities (MBS) market has grown exponentially.

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.

A Variety of MBS Meet Different Investor Needs
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.

“Our strict capacity discipline enhances our ability to exploit inefficiencies in the mortgage market.”

TYPE OF MBS DESCRIPTION BENEFITS
PASS-THROUGH SECURITIES
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.
CMOs
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.

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.

Alpha measures excess return relative to the market that is attributable to active portfolio management.

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.

back to top
>>>>>>>>>>>>>>>>>>>>>>>>