The Risks and Returns of Mortgage-Backed Securities (MBS)

Mortgage-backed securities (MBS) are groups of home mortgages that are sold by the issuing banks. They are packaged together into “pools” and then sold as a single security. This process is known as "securitization."

When homeowners make mortgage payments, those cash flows pass through the MBS; then, they go through to bondholders (minus a fee for the entity that originates the mortgages). MBSs most often offer higher yields than U.S. Treasurys, but they also carry risks. These include reinvestment risks, prepayment risk, and the risk of negative convexity.

What Is MBS Prepayment Risk?

The unique aspect of mortgage-backed securities (MBS) is the element of prepayment risk. This is the risk investors take when borrowers decide to pay the principal on their mortgages ahead of schedule. The result, for investors in MBSs, is an early return of principal; or, there could be a reduction in interest income if the borrower makes larger payments to pay the mortgage down more quickly.

The principal value of the underlying security shrinks over time, which in turn leads to a gradual reduction in interest income. Prepayment risk is typically highest when interest rates are falling; it leads homeowners to refinance their mortgages.

Interest Rate and Average Life of MBSs

Prepayments reduce the mortgage value to investors. This is not only because the interest income on the investment is reduced; it's also because the investor is then forced to reinvest at lower rates when the mortgage is paid off.

The average life of an MBS declines more rapidly when rates are falling. That's because homeowners refinance more when rates are going down. It drops more slowly when rates are rising; higher rates generally reduce the amount of refinancing actions. This can lead to uncertain cash flows from individual MBSs as well as the tendency for negative convexity.

What Is Negative Convexity?

Mortgages act similarly to bonds: When rates go up, prices go down. But MBS prices tend to increase at a decreasing rate when bond rates are falling; in turn, their prices tend to decrease at an increasing rate when rates are rising. This is known as "negative convexity." It's one reason why MBSs offer higher yields than U.S. Treasurys.

In short, investors expect to be paid more to take on this added uncertainty. MBSs tend to perform best when prevailing rates are stable.

Agency vs. Non-Agency MBS

Mortgage pools can be created by private entities in most cases. They can also be created by the three quasi-governmental agencies that issue MBSs: Government National Mortgage Association (known as GNMA or Ginnie Mae); Federal National Mortgage (FNMA or Fannie Mae); and Federal Home Loan Mortgage Corp. (Freddie Mac).

The most concise explanation of the differences among the three comes from the U.S. Securities and Exchange Commission (SEC):

"Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as 'private-label' mortgage securities."

MBSs backed by Ginnie Mae aren’t at risk of default. But there is a small degree of default risk for a bond issued by Fannie Mae and Freddie Mac. Still, Freddie and Fannie's bonds have a stronger element of backing than they appear to; both were taken over by the federal government in the wake of the 2008 financial crisis.

How Can You Invest in an MBS?

You can buy individual MBSs through a broker, but this option is limited to those with the time and knowledge to conduct their own fundamental research. This research should take into account the average age, geographic location, and credit profile of the underlying mortgages.

Many people who own a broad-based bond mutual fund or exchange-traded fund (ETF) have some exposure to this sector since it is such a large portion of the market. It is heavily represented in diversified funds. You can also opt for funds that are dedicated solely to MBSs. Some of the ETFs that invest in this space are:

• Barclays Agency Bond Fund (AGZ)
• iShares Barclays MBS Fixed-Rate Bond Fund (MBB)
• Mortgage-Backed Securities ETF (VMBS)
• iShares Barclays GNMA Bond Fund (GNMA)
• SPDR Barclays Capital Mortgage Backed Bond ETF (MBG)