Totalling around $3trn in outstanding debt, the size of the US mortgage market exceeds that of both US Treasuries and corporates. Yet, for investors outside of the US, the US mortgage market can often be overlooked. It is a complex and specialised marketplace. However, with appropriate investment expertise, mortgages can contribute incremental value to a fixed income portfolio whether in the context of a global aggregate strategy or as a standalone asset class, which forms part of a multi asset class approach towards fixed income portfolio construction.1 Historically, the sector’s diversity, high credit quality and attractive yield spreads over duration matched Treasuries has allowed for an attractive risk-reward profile.
Development of the marketplace
Although in existence for 66 years, the growth of the secondary US mortgage sector accelerated after 1970 with the emergence of mortgage backed securities (MBS). The re-structuring of the Federal National Mortgage Association (FNMA) in 1968, with the partial privatisation of this entity and the setting up of the wholly government owned Government National Mortgage Association (GNMA), alongside the establishment of the Federal Home Loan Mortgage Corporation (“Freddie Mac”) in 1970, enabled the issuance of pass-through securities.
From a hitherto whole loan market, where investors assumed the entire risk of the mortgage loan, securitisation allows investors to participate, pro-rata, in the principal and cash flow of an underlying pool of mortgages. To detail the process, the above agencies purchase the mortgage loans from originators. These loans are then re-packaged, by isolating the receivables and associated cash flows, into pass-through securities. Further, the agencies guarantee the securities, from a credit perspective, for timely interest and principal payments, even if the homeowner defaults on his mortgage.
The introduction of collateralised mortgage obligations (CMOs) in 1983 and the development of other synthetic MBS structures following tax reform in 1986 expanded the universe further. Pass-through securities, however, continue to be the most common structure for MBS, and the major indices are comprised of agency-backed pass-through securities.
Favourable supply – demand
Structural developments have created a dynamic marketplace. Securitisation has ensured the effectiveness of FNMA’s original charter: to stimulate housing supply, demand and funding. Local mortgage markets are better integrated with national capital markets, assisting in the provision of low cost residential mortgages to the US consumer. Moreover, accessibility to the capital markets enables mortgage originators to finance additional lending. By selling mortgage loans on to the agencies, originators effectively remove these loans from their balance sheets, allowing depositories the ability to make more loans available than would otherwise be possible. All participants are advantaged: lenders, borrowers, and the agencies.
GNMA accounted for the majority of the early issuance, but by the mid-1980s this trend was overturned by FNMA and Freddie Mac. Figure 1 shows the meteoric growth in agency mortgage issuance since 1998. Primary market activity is heightened during periods of re-financing, such as when the Federal Reserve’s bias is towards a monetary easing policy and interest rates are falling. During such times, prepayment activity is large, resulting in high gross issuance.
Equally, demand has been met by a more diversified investor-base as MBS have become a core part of fixed income holdings. In recent years, greater interest is now being observed among non-US investors, who comprise 15% of total MBS holdings. Domestic banks and agencies continue to be the largest holders of the asset class (see Figure 2).
Several reasons explain the increase in investor demand. As well as offering the advantages of a large, liquid and homogenous asset class, there are two significant contributions that the MBS sector has historically provided to a diversified fixed income portfolio: a high quality bias and an attractive risk-reward profile.
Like US Treasuries, GNMA bonds are backed by the full faith and credit of the US government and are considered to carry no credit risk. FNMA and Freddie Mac are assumed to have minimal credit risk because of their close ties to the government.2
Secondly, returns versus AAA-rated corporates have been comparable and achieved through lower levels of volatility (see Table 3). Moreover, when viewed against the entire credit spectrum on a risk-adjusted basis, the investment case for MBS has been compelling. Over a 15-year period, MBS has a demonstrably higher Sharpe ratio; across credit sectors the average excess return is more than 20 basis points. This level of outperformance, on a risk-adjusted basis, is also the same against US Treasuries. While helping to control portfolio volatility, the MBS sector has provided an attractive yield spread premium over US Treasuries (typically, 100 basis points). Analysis of this yield spread is crucial to providing further insight into the MBS asset class.
Uncertainty of cash flows: a distinct feature
Distinct from other conventional fixed income instruments, MBS are subject to one fundamental complexity: the uncertainty of the timing of cash flows. There are two principal risks: (1) call risk associated with early prepayment and (2) extension risk associated with delayed pre-payment.
When interest rates are falling, mortgage borrowers are likely to exercise their right to re-finance at lower interest rates. They prepay their old mortgage loan which causes the expected average life and effective duration of the securities to shorten at a time when interest rates are falling. Further, the investor now has to reinvest the proceeds at lower rates.
When interest rates are rising, generally prepayment rates slow, as homeowners retain their current mortgages. The average lives and durations of securities in this environment actually lengthen, at a time when interest rates are rising. Now the investor loses the opportunity to invest cash flows at higher interest rates.
The current price of the mortgage security, whether it is at a discount or at a premium to par, will ultimately affect the future price behaviour (and rate of return) of the security. Discount coupons (or those securities that trade below par) should benefit from an early return of principal, while early principal prepayment of premium securities will negatively affect their price.
To crudely exemplify, if an MBS is bought for $105, the investor is vulnerable to capital loss of 5 points if a full prepayment is made the next month at par.
From the above description of risks, it is obvious that the hardest part of managing a mortgage portfolio is projecting the cash flows: Will the mortgage security behave like a one-year security or will it behave as though it is a 10-year security? And, obviously, one’s desirability for either outcome is based on one’s view on future interest rates. Forecasting interest rates and the projected shape of the yield curve is fundamental in any prepayment projection of a given mortgage. Other factors include one’s expectations for housing consumption, the expected appreciation in real estate, borrowers’ demographics, and the strength of the economy – to name a few. But, clearly, the choice of the projected prepayment rate is critical in evaluating and pricing a mortgage security.
This phenomenon of effective duration shortening when interest rates fall and lengthening when they rise is called negative convexity. Specifically, convexity is the measure of how much effective duration drifts with changes in interest rates. Since effective duration is defined as the percentage price change of a security for a small change in interest rates, convexity can be thought to show how that assumed price change will accelerate or decline as interest rates move. As one would expect, negative convexity means it goes against the investor. Thus, there is a yield premium required to incentivise investors to take on this negative convexity. Mortgage investors must evaluate if they think they are being paid enough for this risk, much like corporate investors must evaluate if they are being paid enough for the default (and/or downgrade) risk of a company.
Fortunately, time and experience have provided much insight into the behaviour of borrowers and mortgage securities.
Sophisticated prepayment and evaluation models exist at nearly every investment banking firm, as well as proprietary models that can be built in-house or purchased. Investors have many tools they can use to manage the risks described above, while the market has expanded in diversity and in the number of innovations, in terms of structure and collateral, to accommodate the growing demand for the asset class.
MBS: a value-added contribution
As an asset class, mortgages have provided excess returns to equal duration treasuries almost every year since they have been included in the major indices. They are the largest sector of the Lehman Brothers’ Aggregate Index, and are almost as liquid as the Treasury sector. In short, they have provided much value to investors: diversification, liquidity, AAA-ratings, yield premiums to Treasuries and total return with less volatility than corporates.
Connie Bavely is CFA and head of mortgages and asset-backeds and Fiona Leonard is senior investment writer at T Rowe Price Global Investment Services Limited
1 MBS Fixed Rate sector comprises 35% of the Lehman US Aggregate Index and 19% of the Lehman Global Aggregate Index (as of 31 March, 2004).
2 Due to recent controversies regarding the financial and managerial functions of these government sponsored enterprises, Congress has begun holding hearings and is considering legislation to create a new regulatory oversight structure for such enterprises.