During the financial crisis, some residential mortgage-backed securities and other securitized debt experienced losses in underlying collateral. Fear and skepticism about the stability of securitized products lingers for some investors. However, it is important to recognize that all securitized products are not created equal. As with most fixed income sectors, securitized products consist of many different levels of risk. In this piece, we take a closer look at agency mortgage-backed securities (MBS). We explain the structural characteristics of agency MBS that help to mitigate risk, including the following:
- Conventional agency MBS (Fannie Mae and Freddie Mac) have the implicit backing of the full faith and credit of the federal government; Ginnie Mae is explicitly guaranteed
- Agency mortgage loans, the collateral that underlies agency MBS, can act as a strong diversifier in multi-sector portfolios
- The volatility profile of agency MBS is compelling
- The overall agency MBS market offers strong liquidity
Agency MBS Have High Credit Quality
The backing of agency MBS by the federal government provides a strong credit factor for bondholders. Given that mortgage loans purchased by government-sponsored entities (GSEs) are then guaranteed by the GSEs, investors are protected from defaults on the underlying mortgage loans. In the event of default on an underlying loan, the GSE will step in and make the investor whole. That said, the conventional (or conforming) mortgages1 purchased by Fannie and Freddie have the strongest credit profiles among mortgage borrowers. The question is not if you will get your principal back, but when.
This credit strong point highlights a significant difference between agency MBS and non-agency MBS, which do not have the same credit protections in place. It is important to note that during the financial crisis, no agency MBS investors experienced any principal losses on their holdings.
Mortgages Offer Diversification Benefits
Agency MBS excess returns have had lower correlations compared to other fixed income sectors. This is a key benefit of holding agency MBS in multisector portfolios.
The table below (Figure 1) shows that agency MBS have had a low correlation with other fixed income sectors.
Agency MBS Has Been A Low-Volatility Sector
Agency MBS have offered low standard deviation relative to other investment grade fixed income sectors, as well as being higher-rated on average. (Figure 2).
The Agency MBS Market Has High Liquidity
The agency MBS market now has approximately $8.4 trillion outstanding, making MBS the third largest bond market after U.S. Treasury and corporate bonds.2 The sector generates more than a quarter of U.S. bond market trading volume in any given year—second only to U.S Treasury trading volume.3
Risks Require Attentive Management
The main risk with agency MBS is that the timing of mortgage prepayments on the underlying collateral is uncertain. If interest rates fall and homeowners prepay their mortgages to refinance at lower interest rates, then the duration of the agency MBS will shorten. This tends to occur at the exact time when investors would want a longer duration to take advantage of falling rates.
The opposite occurs in a rising rate environment. Homeowners become “locked-in,” unable to refinance or less likely to move due to higher mortgages rates. In this environment, the duration of the agency MBS typically extends as interest rates rise. This is known as negative convexity, or the rate of change of duration with respect to changing interest rates. Figure 3 shows how convexity has become more negative since the beginning of 2019 and duration has fallen; with the 10-year Treasury note still trading near 2.5 percent, there is a higher probability that mortgage borrowers would refinance.
However, duration risk can be managed by MBS investment teams. Figure 4 shows how a team can put together cash flows that potentially protect the portfolio from increases or decreases in duration as rates move. We constructed two hypothetical pools of Fannie Mae conventional 30-year bonds: one with cash-flow protected features and another with no special distinguishing features. When we applied various changes in interest rates, we see differences in duration between the two pools. For example, for a 100 basis point (bp) increase in interest rates, duration jumps only 20bps to 6.10 percent in the cash-flow protected pool, but jumps 337bps to 7.12 percent in the generic MBS pool. With “pass through” agency MBS, cash flows for bondholders are paid by “passing through” prorated mortgage principal and interest payments on the underlying collateral.
The securitized market has many complexities not present in corporate or municipal bond markets. One of the most important considerations is prepayment risk among borrowers in the collateral pools and whether current spread levels compensate investors for the negative convexity they are taking on. However, these considerations can be managed through an in-depth understanding of the nuances of securitized products, as well as through diligent monitoring of economic trends and of ongoing regulatory changes in the securitized market (see Five Key Themes in the Securitized Market). The higher average ratings relative to certain other fixed income securities, and the low correlation of agency MBS, could benefit investors seeking to preserve capital while finding ways to increase yield.
In general, agency MBS can benefit investors when managed by experienced analysts and traders who understand prepayment risks and the complexity of the asset class. With an experienced investment management team, agency MBS can help investors preserve capital while minimizing the volatility of returns. As with any investment, the appropriateness of agency MBS securities within a portfolio requires consideration of the specific investor's overall financial profile. Risk tolerance levels and financial objectives and needs are just a few of the items to evaluate before making any investment decisions.
 Conventional mortgages must meet stricter criteria for loan size, credit quality, loan-to-value ratio and income.
 SIFMA, as of 4Q18, per data from Bloomberg, Thomson, Fannie Mae, Freddie Mac and Ginnie Mae.
 SIFMA, as of March 2019, based on average daily trading volume for U.S. bond markets.
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