Mortgage-Backed Securities: How MBS Can Boost Your Portfolio

The U.S. mortgage-backed securities (MBS) market has hit a major milestone: total issuance now stands at a staggering $1.6 trillion. This surge reflects a keen interest in MBS as an attractive investment route.

Yet, investors face a few hurdles in this setting. Prepayment risk, interest rate sensitivity, and liquidity concerns are all potential obstacles.

This blog explores the details of MBS, discussing their different types, how they work, and the risks and opportunities associated with them.

Mortgage-backed securities (MBS) are investment products that are created by pooling together a collection of mortgage loans. These securities allow investors to receive payments from the underlying mortgage loans. These payments include both principal and interest.

MBS are typically issued by financial institutions or GSEs like Fannie Mae and Freddie Mac. They help banks free up capital and manage risk while offering investors a stable income stream.

• Agency Mortgage-Backed Securities: Issued by government-sponsored enterprises like Fannie Mae, Freddie Mac, or Ginnie Mae. These MBS come with guarantees that cut credit risk. So, they appeal to risk-averse investors.

• Residential Mortgage-Backed Securities (RMBS): They are made up of residential home loans. RMBS can be agency-backed or non-agency (private-label). Non-agency RMBS carry higher credit risk due to the absence of government guarantees but may offer higher yields.

• Commercial Mortgage-Backed Securities (CMBS): These are backed by loans on commercial properties such as office buildings, shopping centers, and hotels. CMBS have different risk profiles and structures than RMBS. They often involve multiple tranches with varying levels of risk and return.

Mortgage-backed securities operate through a process called securitization. It bundles multiple mortgage loans into a single security that can be sold to investors.

Mortgage loan terms significantly influence MBS risk profiles. Learn more about this with our comparison of 15 vs. 30-year mortgages.

The pricing of MBS is influenced by several factors:

• Interest Rates: MBS prices are directly affected by interest rates. When rates rise, MBS prices fall.

• Prepayment Speeds: If borrowers refinance or pay off their mortgages early, it can impact cash flows and investor returns.

• Credit Quality: The creditworthiness of the mortgage loans affects the MBS's risk and yield.

Interest rates directly impact MBS values. Clarify the key differences between APR and interest rates.

Investors earn returns from MBS through regular interest payments made by homeowners on their mortgages. These payments are passed through to MBS holders after deducting servicing fees.

The cash flow structure can change depending on the type of MBS. Some provide fixed monthly payments, while others have more complicated payment plans.

MBS are important in fixed-income portfolios. They provide diversification and higher yields compared to traditional bonds like U.S. Treasuries.

They allow investors to gain exposure to the real estate market while still benefiting from regular income streams. However, investors must consider the risks of MBS, like prepayment and interest rate risk, before adding them to their portfolios.

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Here are some key benefits and potential drawbacks to consider:

• Higher Yields Than Treasury Bonds: MBS often yields more than U.S. Treasury bonds. This makes them appealing to income-seeking investors who want better, low-risk returns.

• Portfolio Diversification: Including MBS in a portfolio can improve diversification. They tend to behave differently than stocks and other fixed-income securities during various market conditions.

• Prepayment Risk: A key risk with MBS is prepayment risk. This happens when borrowers pay off their mortgages sooner than expected. This can lead to reinvestment challenges for investors who may have to reinvest at lower interest rates.

• Interest Rate Sensitivity of MBS: MBS are sensitive to interest rate changes. When rates rise, the value of existing MBS falls as new issues come with higher yields.

• Liquidity Risk in MBS Investments: It is another concern for MBS investors. During market stress, selling these securities may become difficult without incurring losses.

Refinancing directly contributes to prepayment risk. To better understand homeowner refinancing behaviors, check out how often homeowners refinance.

Investors can purchase MBS through brokerage accounts or mutual funds that specialize in fixed-income investments.

Individual investors can access Mortgage-Backed Securities (MBS) primarily through Exchange-Traded Funds (ETFs). ETFs offer a diverse MBS portfolio. They expose investors to various mortgage pools without buying individual securities.

For instance, the iShares MBS ETF (MBB) focuses on fixed-rate mortgage pass-through securities. They are issued by entities like Fannie Mae and Freddie Mac.

For MBS investments, ETFs are a good choice. They are diversified and liquid. Notable options include:

• iShares MBS ETF (MBB): This fund invests in mortgage-backed securities. They are fixed-rate and from government-sponsored enterprises.

• Vanguard Mortgage-Backed Securities ETF (VMBS): VMBS invests in U.S. agency mortgage-backed pass-through securities. It focuses on those issued by Ginnie Mae, Fannie Mae, and Freddie Mac.

• Angel Oak Mortgage-Backed Securities ETF (MBS): This ETF gives a varied mix of mortgage-backed securities to offer current income.

Evaluating MBS involves analyzing several factors:

• Yield Considerations: Assess the interest income relative to the price paid. MBS often offer higher yields than other fixed-income securities. This compensates for associated risks.

• Prepayment Risk: Understand the chance of borrowers paying off their mortgages early. This can affect cash flow timing and amounts.

• Interest Rate Sensitivity: MBS prices are sensitive to interest rate changes. Rising rates can decrease MBS values, while falling rates may lead to increased prepayments.

• Credit Quality: Review the creditworthiness of the underlying mortgage issuers. Agency-backed MBS have government guarantees, so they carry less risk. Non-agency MBS may be riskier but offer higher yields.

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Banks play a critical role in the MBS market by originating, pooling, and securitizing mortgage loans. Initially, banks give mortgages to homebuyers. They then pool these loans to create mortgage-backed securities. This process involves several steps:

• Origination: Banks assess borrowers' financial profiles and issue mortgage loans.

• Pooling: Once enough loans are made, banks bundle them into pools. They base this on similar traits, like interest rates and terms.

• Securitization: These pools are sold to a trust or GSEs, such as Fannie Mae or Freddie Mac. They then turn these pools into MBS for investors.

This process lets banks manage risk and free up capital. They can issue more loans. It gives investors access to the cash flows from the mortgages.

Banks often work closely with skilled mortgage loan originators who ensure mortgage loans meet the criteria for securitization.

Mortgage servicers manage the daily operations of mortgage loans in MBS. They are essential to this. Their responsibilities include:

• Collecting Payments: Servicers collect monthly mortgage payments from borrowers. They must distribute these payments to MBS investors.

• Managing Escrow Accounts: They handle escrow accounts for property taxes and insurance. They make sure these costs are covered.

• Handling Delinquencies: If borrowers default or fall behind, servicers work with them to explore options like loan modifications or foreclosures.

Mortgage servicers help maintain MBS investments. They make sure investors get their expected returns by performing these functions.

Mortgage-backed securities offer stable returns but with lower yields than direct property ownership. They come with passive income, but also interest rate and prepayment risks. In contrast, real estate investments bring higher long-term gains and rental income, making them more lucrative.

However, buying a home has become increasingly expensive, especially with the 3-6% realtor commission eating into potential savings. This added cost can make real estate investments less attractive despite their higher returns. Reducing these upfront expenses is important for maximizing profits when purchasing a property.

Considering direct property investment? First, secure your financial footing with our guide to mortgage pre-approval.

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Yes, you can invest in MBS through brokerage accounts. You can buy individual MBS or invest in MBS-focused ETFs that pool securities for diversification.

Rising interest rates usually lower MBS prices. They increase the chance of homeowners refinancing, which affects cash flow. Conversely, falling rates can boost MBS values by reducing prepayment rates.

Yes, MBS offers diversification benefits by providing exposure to fixed-income assets tied to real estate. They can help balance equity-focused portfolios and offer good yields. However, they also carry specific risks.

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