“US mortgage-backed securities have the highest Sharpe ratios of all US asset classes, stock or bond. Bonds in general have a higher Sharpe ratio than stocks going back ten years. But even among bonds mortgage-backed securities have had the highest Sharpe ratios.This fact surprises many people.
“Conventional wisdom states that mortgage-backed securities are tricky, and probably riskier than other classes of securities and might provide inferior returns once risk is taken into consideration. But the fact is that they have had the highest risk-adjusted returns over the last 10 years. Over this time TCW’s mortgage-backed securities portfolios have had a Sharpe ratio that is more than triple that of most stock indices. This means that investors would have tripled their returns, with the same bumpiness of the ride, if they’d been invested in TCW’s mortgage-backed securities approach leveraged a couple of times instead of in equities.
“Will the future provide the same outcome? It is difficult to predict forward-looking Sharpe ratios in absolute terms, especially for classes of equities for which returns are hard to forecast even if volatility remains fairly constant at around a 15% annualised standard deviation. But in the bond market we can project at least relative forward-looking Sharpe ratios with some confidence because for bonds we have good proxies for forward-looking relative returns and volatilities. The proxy for forward-looking return is yield, and that for volatility is duration, or maturity. So for bonds, it is almost as easy to look forward as it is to assess the historical data.
“Today the risk-free rate in the US is a little more than 2%. Mortgage-backed securities yield a little over 5%, so they have about a 3% excess yield versus the risk-free rate. Their duration is about four years, assuming interest rates rise a little. So the forward-looking Sharpe ratio estimate is 0.75. Treasury bonds as a sector yield about 3.5%, which is about 1.5% above the risk-free rate. Since the Treasury sector’s duration is about five years, their relativistic forward-looking Sharpe ratio is 0.30. The difference of 0.45 between the forward-looking Sharpe ratios of mortgage-backed securities and Treasuries is pretty close to the historical empirical difference.
“And then we can look at corporate bonds as a sector. Their yield today is in the mid-4% range, or about 2.25% higher than the risk-free rate. But this sector’s duration is around six years, so their forward-looking Sharpe ratio is about 0.40, a little bit higher than that of Treasuries and well below that of mortgage-backed securities.
“All this reveals that the relativism that has been shown historically is also reasonable to expect going forward. So mortgage-backed securities have the highest historical Sharpe ratio and are likely to continue to looking ahead. Investors should therefore look to mortgage-backed securities as a place to find high risk-adjusted returns.
“Mortgage-backed securities account for 40.2% of the US bond market, compared with 24.6% for US corporate bonds, 23.8% for US treasuries and 11.3% for US agencies. So any investor thinking even narrowly about how to approach the US bond market needs to think about mortgage-backed securities.
“However, rational thinking would go further and say that one should consistently overweight US mortgage-related securities because of their superior attributes. But even those who take a simplistic capitalisation-weighted approach to the world are still faced with the challenge of thinking about US mortgage-backed securities because there are so many of them.
“A consideration of mortgage-backed securities must acknowledge that one takes on a heightened degree of reinvestment risk versus other bond sectors with these investments. This is because in the US virtually all mortgages are pre-payable, or refinanceable, at the homeowner’s sole discretion. When interest rates are low homeowners will choose to pay off their mortgages, which is bad for mortgage-backed investors, and when interest rates are high homeowners will hang on to their loans and be less inclined to refinance them, which is also bad for mortgage-backed investors.
“These might be the reasons why there is a conceptual resistance to mortgage-backed securities: the pre-payment dynamic always appears to be bad. But all of this is calculated into the historical return data. The superior results of mortgage-backed securities versus other sectors suggests that the extra yield paid by these securities is, or at least has been, high enough to produce superior Sharpe ratios.
“A standard approach to bond investing is to downgrade portfolio credit quality. As one goes down in credit, one gets more yield. But when doing so one is also more exposed to defaults, and the hoped for yield is eroded by capital losses due to non-repayment of principle and interest. The actual results going back nearly 20 years reveal that downgrading below the investment grade category has been a losing proposition systematically and that all investment grade bond sectors have had similar returns. So the common approach of downgrading and taking credit risk has been of no particular value.
“A very common belief is that mortgage-backed securities are a bad place to be when interest rates rise. But exactly the opposite is true. If one looks at the data from all negative bond markets going back to 1994 (the worst bond market in the US) one can easily see that in every case mortgage-backed securities outperformed both the treasury and corporate sectors on an absolute basis. There are no exceptions.
“How are these results accomplished? TCW believes the highest confidence method of outperforming in the bond market is security selection, or picking individual issues which are inefficiently priced. The mortgage-backed securities landscape is particularly fertile for security selection because there are very few investors trying to exploit these inefficiencies. For example, there are only 10 active mortgage-backed securities managers in the intermediate-term Frank Russell database. Why so few? Because of the dominant industry paradigm, which is for fixed income to be largely indexed to the Lehman Aggregate.
“Lehman Brothers, the largest index purveyor, believes that mortgages have a slightly negative risk-adjusted return versus treasuries. This belief is based on a flawed analytic process. The problem is that their duration is wrong and since interest rates have fallen they think mortgages should be up a certain amount. But since they have calculated too long a duration they are not up to the expected level so they have underperformed. But the duration of mortgages is a guess, a range. They are using analytic assumptions to draw conclusions. But there are no assumptions in returns. The Sharpe ratio is the Sharpe ratio, the returns are the returns.
“Rational thinking would argue for beginning with superior risk-adjusted asset classes and building alpha above their already strong returns. This is the approach TCW takes regarding mortgage-backed securities. There is a two-pronged benefit: the superiority of the asset class itself, with the highest Sharpe ratio so that simply an indexation approach would be profitable, coupled with the ability to add alpha thanks to dedicated skill amid little competition.
“Why don’t more investors take this approach? Because it is unconventional, and in the world of investments the majority of participants will favour conventional failure over unconventional success. People are afraid that when an unconventional approach does not excel even for a short while it will expose them to ridicule. And the US institutional bond investment industry is dominated by consulting firms. Unfortunately, these firms populate the fixed-income analyst pool with relatively junior staff, thinking that resources are best allocated elsewhere. The new hires placed in fixed income analysis who show promise are quickly promoted to equities or alternative investment activities. Bonds are approached though indexation, and often not further explored.
“Yet the investment culture is showing signs of change in the fixed income arena. It must change since the indexation approach is no longer working. Bond market returns for the last 20 years have been acceptable to meet funding expectation for pension plans, endowments and foundations because the 8% generated has been what was needed and it has been what indexed bonds have delivered. But the 8% goals of these entities have not come down. One doesn’t need a PhD the realise that a 4% index fund bond yield is unlikely to deliver 8%. So now the question arises: ‘I don’t know what to do with my bonds.’ This is tantamount to a statement that ‘Lehman Aggregate indexing doesn’t work for me going forward’. So new ideas are starting to be considered. The investment world is starting to realise it needs active management of bonds more than ever. And that mortgage-backed securities, actively managed, hold the greatest promise.”