Mortgage-backed securities (MBS) - we’ve come a long, long way together ...
In many ways, we have come a long way since the US sub-prime mortgage crisis of 2008. The first quarter of 2018 marked ten years since Bear Stearns, one of the investment banks most entangled in this market, was driven to the brink of bankruptcy and forced to merge with JP Morgan. But should the assets at the epicentre of the crisis – mortgage-backed securities (MBS) – still be viewed with distrust?
What are mortgage-backed securities (MBS)?
Despite the stigma attached to mortgage-backed securities (MBS), they can be attractive if we forget their infamy and focus objectively on what they currently offer.
Whenever a consumer takes out a loan, this becomes an asset on the balance sheet of the lender. In the case of mortgage-backed securities, these are US mortgages (assets) which are sold to either government agencies (Freddie Mac, Fannie Mae or Ginnie Mae) or investment banks (generically known as non-agency), who package them up together into an MBS that investors can buy. MBS offer a yield (equating to the interest paid on the mortgages), together with the possibility of pre-payments if mortgage holders pay off part of their mortgage early.
Government agencies will guarantee against the risk of homeowner default, although only in the case of Ginnie Mae is this guarantee offered with the full backing of the US government. The financial crisis of 2008 was caused by the fact that many mortgage-backed securities were secured by mortgages which were almost certain to default, but which were sold as ‘risk-free’ investments.
Getting over the infamy of mortgage-backed securities (MBS)
This is not the US housing market of 2008. The fundamentals of the US housing market are much stronger than they were a decade ago. New home prices are still 20% below their long-run average, making them more affordable, while fewer homeowners are in arrears on their mortgages. Pre-payments – which should be welcomed by MBS holders – have also risen from 4% in 2012 to over 11% (at end 2017), while loan to value rates have fallen from 110% to near 65%. There are very few reasons nowadays to be concerned about a bubble in the US housing market.
Attractive risk/return profiles of mortgage-backed securities
It is very easy to be deterred by the reputation of the MBS assets, their seeming complexity and the memories of 2008’s financial crisis, but it is extremely unlikely that the next financial crisis will be caused by the same issues. We would not advise direct exposure to MBS, given the significant research which is required to understand the risks inherent within the security, which may include assessing whether agency or non-agency mortgage-backed securities offer a better risk/return trade-off. To complicate matters, MBS may be split into different tranches, each of which may offer varying exposure to different US states, and different credit rating characteristics. Instead, we feel that investors are better served by sub-contracting the management of this area to specialists via a fund.
Due to continued investor wariness, MBS are still trading at a discount to other credit instruments. Yields of 5% are available; pre-payments could feasibly push this return toward 7% - 9% pa. In many cases, MBS also offer a floating rate yield. Their yield rises as interest rates increase but, unlike other credit instruments, they are not susceptible to a corresponding fall in price.
Unless there’s a period of significantly heightened volatility such as the extreme stress of 2008, these assets should offer protection, and arguably they are already priced for a negative economic outcome. In anything other than this worst-case scenario, MBS should outperform.
We have introduced an exposure to MBS via a specialist fund across many of our portfolio strategies, as we believe markets have indeed come a long, long way since 2008, with mortgage-backed securities making a positive contribution to our clients’ diversified portfolios. However, as always, we will maintain a very close watching brief.
Securing exposure in a diversified portfolio to complex assets such as MBS can require professional expertise. If you would like to know more about our discretionary portfolio service and how we might be able to help you, please contact us:
phone: 0207 523 4600
Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.
The tax treatment of all investments depends upon individual circumstances and the levels and basis of taxation may change in the future. Investors should discuss their financial arrangements with their own tax adviser before investing.
The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.