Relatively high yields mean investors who have been focusing on short-term securities wouldn’t need to sacrifice much yield if they chose MBS to help limit their reinvestment risk.
Mortgage-backed security yields remain high, and they can make sense for investors looking to extend duration to help reduce reinvestment risk once the Federal Reserve begins to cut rates.
Extending duration has been a key theme of ours for months. Short-term yields, like those offered by Treasury bills or money market funds, tend to fluctuate with the federal funds rate. While high now—Treasury bills with maturities of six months or less generally have yields above 5%—they should begin to fall once rate cuts become more likely.1 That could force investors to reinvest maturing securities at lower yields, a situation known as reinvestment risk. Investors should consider some intermediate- or longer-term investments to help reduce reinvestment risk by paying those higher yields for longer.
Mortgage-backed securities (MBS) may fit that bill: The underlying mortgages that make up the securities generally have 30 years to maturity when issued but often will be paid off earlier than 30 years. Mortgage-backed securities also have unique characteristics compared to traditional bond investments like U.S. Treasuries, so investors should be aware of how they work before considering them as an investment. Below we discuss what investors need to know before investing and how MBS yields stack up today compared to other highly rated alternatives.
Mortgage-backed securities: the basics
A mortgage-backed security is a type of investment that is backed by a pool of underlying mortgages. As homeowners make their monthly mortgage payments, those payments are passed on to holders of mortgage-backed securities. This makes MBS investing a little less straightforward than investing in traditional bonds, because:
- Monthly payments include both interest and principal. Unlike traditional bonds that generally make semiannual interest payments and then repay the principal amount at maturity, a MBS pays its principal down over time. Consider a monthly mortgage payment for a homeowner—it’s usually a combination of both interest and principal. As time passes, the original principal value of your investment will decline because that principal is slowly being returned back to you.
- Monthly payments may fluctuate. Depending on how quickly homeowners pay down the underlying mortgages, the flow of interest and principal payments to MBS holders may vary.
- Prepayment risk. As interest rates fall, homeowners tend to refinance their mortgages, leading to a quicker pay-down of mortgage-backed securities. This is a risk for investors, as they are receiving their money back at a time when interest rates have fallen, meaning they may have to reinvest the proceeds into lower-yielding investments. Today, prepayment risk seems relatively low since so many homeowners locked in historically low interest rates, so it would likely take a large drop in mortgage rates to make it economically advantageous for many homeowners to refinance and pay off their original mortgages. There are other drivers of prepayment, of course, like relocation for a new job.
- Extension risk. This is the opposite of prepayment risk. If interest rates rise, homeowners are unlikely to prepay their mortgages. MBS holders would likely receive their principal back later than initially assumed, potentially missing out on the opportunity to invest that principal into higher-yielding securities.
These nuances are important when considering mortgage-backed securities for a fixed income portfolio, especially for those trying to plan for future liabilities. If you’re planning for some sort of future expense, mortgage-backed securities might not be as appropriate as traditional bonds with stated maturity dates.
There are many types of mortgage-backed securities, but here we will focus on those that are guaranteed by government agencies:
- Ginnie Mae, or the Government National Mortgage Association, is a government-owned corporation within the U.S. Department of Housing and Urban Development. As an actual government entity, the principal and interest payments of Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. government.
- Fannie Mae, or the Federal National Mortgage Association, is a federally chartered corporation—subject to government regulation and oversight—but is not government-owned like Ginnie Mae. While generally understood to have the implicit backing of the U.S. government, mortgage-backed securities guaranteed by Fannie Mae are not backed by the full faith and credit of the U.S. government and therefore have increased credit risk compared to Ginnie Mae mortgage-backed securities. For example, Fannie Mae’s guarantee of timely interest and principal payments is predicated on the agency’s financial ability to do so. If it were unable to help with those payments, it only has the implicit backing of the U.S. government, as opposed to explicit backing that Ginnie Mae mortgage-backed securities have.
- Freddie Mac, or the Federal Home Loan Mortgage Corporation, is also a federally charted corporation. Like Fannie Mae, it’s regulated by the government, but its mortgage-backed securities are not backed by the full faith and credit of the U.S. government.
