The U.S. mortgage securities market is enormous at $8 trillion, but it gets little attention from investors. That’s a mistake because yields on mortgage securities, now in the 4.5%-to-5.5% range, are unusually appealing relative to U.S. Treasuries, and carry little or no credit risk.
“Mortgage securities are not only cheap on an absolute basis, but also cheap on a relative basis,” says Dan Hyman, a portfolio manager of the
Pimco Mortgage Opportunities and Bond
fund (ticker: PMZIX). Hyman notes that corporate bonds—the main alternative to mortgage securities—trade near their historic averages relative to Treasuries.
There are other high-profile fans of the mortgage sector, including “bond king” Jeffrey Gundlach, the founder and CEO of DoubleLine Capital, and Dawn Fitzpatrick, chief investment officer at Soros Fund Management.
The market for mortgage-backed securities, known as MBS, has been under pressure because the two largest investors in the sector—the Federal Reserve and U.S. banks—have gone from buyers to sellers in the past year.
That trend may continue as the Fed reduces its massive balance sheet and banks see deposit outflows. The $100 billion mortgage portfolio of failed Silicon Valley Bank, for instance, is estimated to be only about a third liquidated. But inexpensive markets often attract buyers.
Gundlach, on an investor call, recently said that “mortgages are the cheapest part of the fixed-income market on a risk-adjusted basis.”
A good way to play the mortgage market is through mutual funds and exchange-traded funds. While investing directly in municipal bonds is relatively simple, it’s tougher in the mortgage market due to issues like liquidity and complex cash flows.
|Fund / Ticker||1-Yr Total Return||5-Yr Total Return||Assets (bil)||Yield||Expense Ratio|
|DoubleLine Total Return Bond / DLTNX||-0.9%||0.0%||$33.5||5.0%||0.73%|
|American Funds Mortgage / MFAAX||-0.5||0.6||9.0||4.5||0.64|
|Pimco Mortgage Opportunities and Bond / PMZIX||2.2||1.8||7.3||5.1||0.60|
|ETF / Ticker|
|iShares MBS / MBB||1.1%||0.1%||$27.2||4.6%||0.04%|
|Vanguard Mortgage-Backed Securities / VMBS||1.2||0.1||15.6||4.3||0.04|
|SPDR Portfolio Mortgage Backed Bond / SPMB||0.8||0.1||4.4||4.7||0.04|
Note: Returns through June 13. Five-year returns are annualized.
Sources: Bloomberg; Morningstar; company reports
Mortgage securities are backed by pools of residential mortgages, with investors getting the principal and interest payments on the loans. They may be better suited to individual retirement accounts and other tax-free accounts since interest is fully taxable and not exempt from state and local taxes as is Treasury interest.
The largest mortgage ETFs are the $26.5 billion
(MBB) and $17 billion
Vanguard Mortgage-Backed Securities
(VMBS), with yields to maturity of about 4.5%. While current yields are closer to 3%, they hold securities at discounts to face value, resulting in higher yields to maturity.
The largest mutual fund is the $34 billion
DoubleLine Total Return
(DLTNX), which is run by a team led by Gundlach. Other big funds are the
American Funds Mortgage
(MFAAX) and the Pimco offering.
The DoubleLine and Pimco funds yield 5%—more than the iShares and Vanguard ETFs—because they hold both mortgage securities from government-sponsored entities such as Fannie Mae and Freddie Mac, and higher-rate nonagency MBS often backed by high-balance “jumbo” mortgages.
Many mortgage funds have had uninspiring annualized returns in the zero-to-1% range over the past five years. This reflects the impact of higher rates and wider spreads between MBS and Treasury yields. The key, however, is the entry yield. It’s now the most attractive since the financial crisis, which bodes well for future returns.
Mortgage managers focus on the yield gap, or spread, between agency mortgage securities—issued by Fannie, Freddie, and Ginnie Mae—and U.S. Treasuries. That spread for new 5.5% MBS is now 1.75 percentage points, about a point more than the 20-year average. The spread on investment-grade corporate bonds is about 1.25 percentage points, in line with their historical average.
The credit risk on agency MBS is low because Ginnie Mae securities carry a government guarantee, and Fannie and Freddie securities have an implied federal backing. The government seized Freddie and Fannie during the 2008-09 financial crisis. Both have built sizable capital bases and are more conservatively run than before.
Given their importance to the U.S. housing market, it’s likely that the government will stand behind Freddie and Fannie MBS, even if there is no explicit guarantee. That was the case in the financial crisis.
“If you’re concerned about a recession, investment-grade and high-yield corporate bonds carry credit risk. The MBS market is a way to avoid that,” says Brian Quigley, a senior bond manager at Vanguard. His firm upped its exposure to the sector recently.
Why do mortgage securities yield so much, given the lack of credit risk? One reason is the “uncertainty of when they will ‘mature’ and the principal will be returned to the investor,” says Harley Bassman, a managing partner at Simplify. The uncertainty arises because a homeowner can pay off the loan at any time with no penalty, so the “investor needs to be compensated” with a slightly higher yield.
This results in “negative convexity,” meaning that mortgage securities tend to have more price downside than upside. Borrowers with 3% mortgages are loath to pay them off because market rates now are above 6%. But if rates fall, holders of 6% mortgages will be eager to refinance them.
Much of the MBS market consists of 2% and 3% securities that have an attractive risk/reward, given that they trade for 85 cents or so on the dollar. Gundlach says there is no negative convexity in much of the market now.
DoubleLine Total Return holds more than a third of its assets in nonagency mortgage securities, while Pimco Mortgage Opportunities has about 20% in that area. DoubleLine manager Ken Shinoda said recently that the triple-A rated commercial mortgage securities look “compelling,” thanks to high yields stemming from concerns about the office market.
Pimco’s Hyman says there is little credit risk in the fund’s nonagency holdings because most are older loans with considerable homeowner equity and yield about 6%.
With inflation cooling, there is something to be said for 5% yields on supersafe securities. Bond investors ought to take a close look at the massive mortgage-backed market.
Write to Andrew Bary at email@example.com
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