Why to Consider Mortgage-Backed Securities Now

Mortgage-backed security yields remain high, and they can make sense for investors looking to extend duration to help reduce reinvestment risk once the Federal Reserve begins to cut rates.

Extending duration has been a key theme of ours for months. Short-term yields, like those offered by Treasury bills or money market funds, tend to fluctuate with the federal funds rate. While high now—Treasury bills with maturities of six months or less generally have yields above 5%—they should begin to fall once rate cuts become more likely.¹ That could force investors to reinvest maturing securities at lower yields, a situation known as reinvestment risk. Investors should consider some intermediate- or longer-term investments to help reduce reinvestment risk by paying those higher yields for longer.

Mortgage-backed securities (MBS) may fit that bill: The underlying mortgages that make up the securities generally have 30 years to maturity when issued but often will be paid off earlier than 30 years. Mortgage-backed securities also have unique characteristics compared to traditional bond investments like U.S. Treasuries, so investors should be aware of how they work before considering them as an investment. Below we discuss what investors need to know before investing and how MBS yields stack up today compared to other highly rated alternatives.

A mortgage-backed security is a type of investment that is backed by a pool of underlying mortgages. As homeowners make their monthly mortgage payments, those payments are passed on to holders of mortgage-backed securities. This makes MBS investing a little less straightforward than investing in traditional bonds, because:

• Monthly payments include both interest and principal. Unlike traditional bonds that generally make semiannual interest payments and then repay the principal amount at maturity, a MBS pays its principal down over time. Consider a monthly mortgage payment for a homeowner—it's usually a combination of both interest and principal. As time passes, the original principal value of your investment will decline because that principal is slowly being returned back to you.
• Monthly payments may fluctuate. Depending on how quickly homeowners pay down the underlying mortgages, the flow of interest and principal payments to MBS holders may vary.
• Prepayment risk. As interest rates fall, homeowners tend to refinance their mortgages, leading to a quicker pay-down of mortgage-backed securities. This is a risk for investors, as they are receiving their money back at a time when interest rates have fallen, meaning they may have to reinvest the proceeds into lower-yielding investments. Today, prepayment risk seems relatively low since so many homeowners locked in historically low interest rates, so it would likely take a large drop in mortgage rates to make it economically advantageous for many homeowners to refinance and pay off their original mortgages. There are other drivers of prepayment, of course, like relocation for a new job.
• Extension risk. This is the opposite of prepayment risk. If interest rates rise, homeowners are unlikely to prepay their mortgages. MBS holders would likely receive their principal back later than initially assumed, potentially missing out on the opportunity to invest that principal into higher-yielding securities.

These nuances are important when considering mortgage-backed securities for a fixed income portfolio, especially for those trying to plan for future liabilities. If you're planning for some sort of future expense, mortgage-backed securities might not be as appropriate as traditional bonds with stated maturity dates.

There are many types of mortgage-backed securities, but here we will focus on those that are guaranteed by government agencies:

• Ginnie Mae, or the Government National Mortgage Association, is a government-owned corporation within the U.S. Department of Housing and Urban Development. As an actual government entity, the principal and interest payments of Ginnie Mae mortgage-backed securities are backed by the full faith and credit of the U.S. government.
• Fannie Mae, or the Federal National Mortgage Association, is a federally chartered corporation—subject to government regulation and oversight—but is not government-owned like Ginnie Mae. While generally understood to have the implicit backing of the U.S. government, mortgage-backed securities guaranteed by Fannie Mae are not backed by the full faith and credit of the U.S. government and therefore have increased credit risk compared to Ginnie Mae mortgage-backed securities. For example, Fannie Mae's guarantee of timely interest and principal payments is predicated on the agency's financial ability to do so. If it were unable to help with those payments, it only has the implicit backing of the U.S. government, as opposed to explicit backing that Ginnie Mae mortgage-backed securities have.
• Freddie Mac, or the Federal Home Loan Mortgage Corporation, is also a federally charted corporation. Like Fannie Mae, it's regulated by the government, but its mortgage-backed securities are not backed by the full faith and credit of the U.S. government.

Like most bond investments lately, yields are up relative to the last 15 years. The average yield-to-worst of the Bloomberg US Mortgage-Backed Securities Index is currently near 5%, off the recent highs but well above the pre-pandemic trading range. That compares favorably to the average yield of the 10-year Treasury note, which is closer to 4.2%.

It's not an apples-to-apples comparison, but despite the underlying mortgages generally starting with 30-year maturities, it usually doesn't take all 30 years to get the investment back, since most monthly payments include both principal and interest. Over the last 15 years, the Bloomberg US Mortgage-Backed Securities Index offered an average yield advantage of just 55 basis points (or 0.55%) over the 10-year Treasury yield, so that 80-basis-point advantage appears attractive now.

MBS relative yields appear attractive compared to other types of fixed income investments these days. The yield advantage that non-Treasury investments offer above a comparable Treasury is called the "spread." It is usually meant to compensate for additional risks, like credit risk. With agency mortgage-backed securities, which generally make up the Bloomberg US Mortgage-Backed Securities Index, credit risk is very low because the securities have either the explicit or implicit backing of the U.S. government. With MBS, the risk is less about whether you get your money back, but when you will get your money back.

This chart highlights how the current option-adjusted spread (OAS) of each index stacks up compared to its OAS over the last 10 years. For example, investment-grade and high-yield bond spreads have only been this low or lower 10% of the time, but that's not the case with MBS. In fact, MBS spreads have been higher than current levels just 30% of the time over the last 10 years.

Keep in mind that MBS spreads tend to trade in a relatively tight range when you exclude the surge from the early weeks of the COVID-19 pandemic in 2020, and current levels are just five to 10 basis points above the 10-year average. That seems attractive considering that investment grade and high-yield spreads are well below their long-term averages and still close to their cyclical lows. We still find investment-grade corporate bonds attractive, given their strong fundamentals and high absolute yields.

One final point: The average yield-to-worst of an index is rarely the same as the average coupon rate. That's the case with the MBS index today, and it's important given the recent drop—and then rise—in mortgage rates. In 2020 and 2021, many homeowners purchased or refinanced their homes with historically low mortgage rates. As mortgage rates rose, activity slowed significantly. As a result, most mortgages that are outstanding today have very low fixed rates—likewise the average coupon rate of the Bloomberg US Mortgage Backed Securities Index is still below its pre-pandemic levels despite its average yield-to-worst being at the high end of its 15-year range.

Low prices have been the driver of higher yields lately. Bond prices and yields generally move in opposite directions, and MBS are no different. Since the underlying coupon rates were so low, prices generally fell in the secondary market to pull yields up to be more comparable with market rates.

Potential price appreciation can help explain the gap between the 5% average yield-to-worst and the 3.2% average coupon rate. Over time, prices should rise enough where the price gains and coupon payments amount to an average annualized return closer to 5%.

Agency mortgage-backed security yields are still at the high end of their 15-year trading range, and their spreads are more in line with their historical averages compared to many other types of investments. With yields near 5%, investors that have been focusing on short-term investments don't need to sacrifice much yield when considering MBS, while still helping limit reinvestment risk.

Given their relatively high credit quality, agency mortgage-backed securities should be considered as part of a portfolio's "core" bonds holdings. At Schwab, we suggest investors hold up to 20% of their portfolio in agency mortgage-backed securities, but that allocation can vary depending on factors like your risk tolerance, need for income, or need for predictable value at maturity.

Agency mortgage-backed securities can be owned individually or as part of a mutual fund or exchange-traded fund (ETF). However, there isn't a specific category for mortgage-backed securities; they generally fall under the "Intermediate Government" classification and will usually have a reference to mortgage-backed securities in their name. A good place to start is the ETF Select List or Mutual Fund OneSource Select List.

One consideration for investors considering individual mortgage-backed securities: Reinvesting the proceeds of maturing MBS principal can be more challenging than when holding traditional individual bonds. With MBS, the principal payments come in little by little, so the principal value tends to gradually decline, as opposed to traditional bond investments that repays the $1,000 par at maturity.