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The Unique Benefits of Mortgage‑Backed Securities

MBS have potential to outperform U.S. Treasuries with high liquidity and low correlation to risk assets.

This article originally appeared on institutionalinvestor.com on 19 September 2015.

Here’s a multifaceted objective that we have heard from investors over the years, one that is particularly topical considering recent market volatility: How to outperform U.S. Treasuries without drastically increasing the correlation of fixed income holdings to equities, while maintaining a high degree of liquidity.

While only death and taxes are certain, taking a closer look at securities backed by mortgages uncovers some appealing characteristics.

Mortgage-backed securities, or MBS as they are commonly known, have generally tended to offer a high degree of liquidity, a high historical Sharpe ratio and low correlation to risk assets. Moreover, their complexities can create market dislocations, making them a particularly ripe source of potential alpha-generating opportunities for active managers.

While MBS rarely take center stage during investor conversations regarding asset allocation, we believe that a strong understanding of the merits of MBS is important, as the sector can be a useful ingredient in a high quality fixed income allocation. After all, the U.S. residential and commercial MBS markets exceed $7 trillion and make up about 30% of the Barclays U.S. Aggregate Bond Index and 12% of the Barclays Global Aggregate Index, according to the Securities Industry and Financial Markets Association and Barclays, respectively, as of 30 June 2015. The largest and most liquid component of MBS exposure in the Barclays Aggregate is mortgage bonds guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. There also are sizeable private label residential and commercial MBS markets.

Importantly, agency MBS valuations are not cheap at current levels, and these securities are accompanied by both interest rate and prepayment risk. Prices have been inflated by accommodative policies of the Federal Reserve, which owns over $1.75 trillion in agency MBS. However, agency MBS have cheapened year-to-date – and the prospect of less Federal Reserve accommodation and higher interest rate volatility may create the potential for better entry points.

In our view, investors should consider four historical benefits provided by agency MBS:

High historical Sharpe ratio – The agency MBS sector has provided among the most consistent sources of risk-adjusted returns relative to like-duration U.S. Treasuries of any fixed income asset class. More recently, massive central bank accommodation and global demand for yield have resulted in outsize risk-adjusted returns in many credit sectors. However, the agency MBS Sharpe ratio has remained consistent over time.

Volatility sales have often been a primary driver of this phenomenon. Given that the typical U.S. 30-year mortgage loan can be prepaid at any time, the MBS investor (the lender) is short a call option to the borrower to prepay (or call) their mortgage at their discretion. The resulting risk profile is a long position in a government-guaranteed bond and a short position in a call option. Being short an option creates the exposure to volatility. As Figure 1 shows, investors have earned attractive compensation for incurring this risk over the long term.

Figure 1 is a bar chart showing the Sharpe ratios for mortgages versus four other asset classes, for five-year, 10-year and 15-year periods as of 31 July 2015. The Sharpe ratio at five years for the Barclays Fixed Rate MBS was the lowest among the asset classes shown, at about 0.25, compared with non-agency CMBS having a ratio of greater than 1.2, investment grade, 0.4, high-yield, 0.8, and emerging markets USD, about 0.4. But at 10 years, mortgages had the highest Sharpe ratio of 0.3, just slightly above that of high yield and emerging markets. At 15 years, the Sharpe ratio for mortgages was second highest, at around 0.35, just behind that of emerging markets.  356 

Low correlation to risk assets – Excess returns from agency MBS have had among the lowest correlation to risk assets of any fixed income sector (see Figure 2). Unlike many other spread sectors, relative to like-duration U.S. Treasuries the primary risk factor in agency MBS is prepayment risk rather than exposure to credit fundamentals and/or bond market liquidity. Even within the credit component of the MBS market, private label commercial mortgage-backed securities (CMBS) have had a lower correlation to equities than corporate and emerging market debt.

Figure 2 is a bar chart showing the correlation of excess returns versus the S&P 500 for mortgages versus four other asset classes, for five-year, 10-year and 15-year periods as of 31 July 2015. Mortgages had the lowest correlations in any time period. At five years, the Barclays Fixed Rate MBS was 0.5, compared with 0.6 non-agency CMBS, 0.7 for investment grade, 0.85 for high-yield, and 0.75 for emerging markets USD. At 10 years, mortgages had a correlation of almost 0.5, and almost 0.4 at 15 years, the lowest among the five asset classes.

This is a key feature of the agency MBS market, as many bond market investors seek to diversify their overall portfolios. The tendency for agency MBS to achieve this goal is unique in global fixed income markets, especially when compared with corporate credit or emerging market debt, where correlations of excess returns to equities are historically in the 0.6 to 0.7+ range.

Ample liquidity – Liquidity is another key distinguishing factor of the agency MBS sector, especially in an environment where regulation has reduced the role of intermediaries and negatively affected liquidity across many credit sectors. Diminished liquidity can result in wider bid/ask spreads and more fragility during periods of market dislocation. While liquidity in agency MBS may be weaker than historical levels, on average the sector continues to trade more than $200 billion per day (see Figure 3), according to the Securities Industry and Financial Markets Association, and with minimal bid-ask spreads relative to many other credit sectors.

Figure 3 is a line graph showing agency MBS liquidity, expressed in billions of dollars on the Y-axis, from 2002 through mid-2015. The level of liquidity, shaded in blue, was around $260 billion as of 31 July 2015, up from about $100 billion in 2002. Over the one-year period through July 2015, the level was rising, up from about $230 billion, but much lower than its last peak of about $340 billion in late 2012. From 2002, the level rose steadily to a peak of $350 billion in 2008, then fell to about $275 billion by mid-2010, before rising to its 2013 peak.  

This allows for active relative value trading within the sector, in an environment where the beta of agency MBS may be less attractive than historical norms. Long/short trading within the agency MBS market has the potential to be an attractive, liquid alpha source, especially in the current environment.

Active management opportunities – In addition to the attractive characteristics that may be provided by simply owning the beta of MBS, the complexity of the mortgage market has facilitated consistent, excess return potential. Prepayment risks are intricate, and sophisticated MBS investors often disagree materially on the value of embedded call options. In addition, given the large footprint of investors not driven by total return goals, the agency MBS market is constantly dislocated and mispriced. This can result in frequent, attractive and liquid opportunities for active managers to extract additional risk-adjusted returns above and beyond what passive exposure to the sector has historically provided. In private label mortgage markets, differences in collateral and security structures, among several other factors, may provide further opportunities for excess returns.

At home with MBS

The MBS market offers the potential for investors to outperform U.S. Treasuries without drastically increasing the correlation of their fixed income holdings to their equity exposure, while still maintaining a high degree of liquidity. The agency MBS sector historically has demonstrated a tendency to successfully address these goals, while also providing attractive opportunities for active managers to generate excess returns. This may be especially so as we enter a period of less accommodative Federal Reserve policy and higher interest rate volatility.

The Author

Jason Mandinach

Head of Alternative Credit and Private Strategies

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Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

The Sharpe Ratio measures the risk-adjusted performance. The risk-free rate is subtracted from the rate of return for a portfolio and the result is divided by the standard deviation of the portfolio returns. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

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