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What Are Mortgage-Backed Securities?
MBS are bonds that represent an ownership interest in a pool of residential mortgage loans. Homeowners make mortgage payments which are ultimately pooled each month and then “passed through” to MBS holders in the form of principal and interest cash flows. MBS are classified as either agency MBS or non-agency MBS. Agency MBS are created by one of three US government-sponsored agencies: Fannie Mae, Freddie Mac or Ginnie Mae (GNMA). Ginnie Mae bonds are backed by the full faith and credit of the US government and their credit is comparable to US Treasury securities. Fannie Mae and Freddie Mac bonds aren’t US government guaranteed, but they are under conservatorship of the US government and regulated by the Federal Housing Finance Agency. In contrast, non-agency MBS are issued by private entities, such as financial institutions. They are not guaranteed by the US government or any of the three government-sponsored agencies, and therefore carry a level of credit risk that is not present in agency MBS. [/perfectpullquote]
As COVID-19 spread throughout the global economy and financial markets, March 2020 was an exceptionally volatile month within the MBS sector. Yield spreads to similar duration US Treasuries in the sector widened the most since the global financial crisis (GFC) a decade ago, then sharply tightened after the US Federal Reserve (Fed) announced a massive support program to boost liquidity and provide stability across US government securities including agency MBS. The Fed’s active MBS purchases have been supportive of the asset class, and spreads have returned to a more normalized level, albeit still trading wider than pre-GFC levels.
Since the Fed’s announcement in March, the Federal Reserve System Open Market Account (SOMA) has absorbed a large share of market supply, purchasing US$617 billion as of May 7. We believe Fed buying will continue, keeping spreads well supported and range-bound.
The overall housing sector is facing opposing forces, which are leading to market uncertainty. While the low-interest-rate environment continues to be a tailwind and seasonal purchases have been strong, social distancing and other measures as a response to the COVID-19 pandemic could lead to lower housing activity.
Prepayment Risk Elevated
Prepayment risk—the premature return of principal on a fixed-income security—is the primary risk to investors in agency MBS. When interest rates decline, many homeowners refinance their mortgages to secure a lower rate and lower their monthly payments. As a result, mortgages are paid off prior to maturity, and the MBS investors are confronted with reinvesting that money at a lower prevailing interest rate.
Today, prepayment risk remains elevated as mortgage rates are near record lows, and nearly three-quarters of the agency MBS universe has an incentive to refinance, leading to high levels of refinance applications. However, two factors may keep prepayments muted over the short term: forbearance requests related to the COVID-19 crisis have picked up, and capacity constraints combined with the disruptions related to the crisis could lead to fewer refinance applications being processed each month. We are positioned toward lower coupons to guard against prepayments, as lower coupons/rates have less incentive to refinance versus higher ones.
Fed Buying Should Continue to Support MBS
As you can see in our recently released fixed income views piece, we have slightly upgraded our view to neutral for the MBS sector as we believe that the sector will continue to benefit from Fed purchases and represents a stronger income opportunity within the government space. However, our view is offset somewhat by elevated prepayment risk and relatively tight spreads.
Because of either direct (in the case of GNMA), or indirect (in the case of Fannie Mae and Freddie Mac) guarantees by the US government, the agency MBS market has tended to see stronger demand during periods of stress. The sector provides what is generally considered to be very high-quality income to portfolios, while also providing a high-quality duration exposure that may help to offset other risks in a portfolio, including equity risk.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The price and yield of a mortgage-backed security will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. Bond prices generally move in the opposite direction of interest rates. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value.