After the housing bust, the Fed decided to help homeowners by keeping mortgage rates low. To implement this policy, it embarked on a $40 billion per month purchase of mortgage-backed securities (MBS). This drove the prices of MBS higher, resulting in record low interest rates. However, recently the Fed hinted that it would reduce these purchases, sending waves of fear through the MBS market. The price of mortgage-backed securities cratered. Is this a buying opportunity? To asses this asset class, I analyzed the risk and reward associated with MBS over the past few years.
Before I delve into the analysis, it might be instructive to review the characteristics of mortgage-backed securities. Many years ago, most mortgages were issued by your local bank, which serviced this mortgage over the life of the loan. Then someone had the idea that banks could sell these mortgages to another company, who could bundle these loans into packages that could be sold to the public. This process was called securitization. The mortgages were sliced and diced into "shares" of the mortgage pool, with each share receiving a portion of the interest and principal as the underlying mortgages are repaid. These shares were referred to as mortgage-backed securities. The majority of MBS are pooled together by government-sponsored enterprises (GSE) such as Ginnie Mae, Freddie Mac, and Fannie Mae and are called agency MBS. If the MBS is sponsored by a private company, it is called a non-agency MBS.
Mortgage-backed securities are like bonds since they have a coupon or interest rate, but they are different in that the principal is repaid incrementally. Since mortgages may be paid off early, mortgage securities are tracked in terms of their "average life" rather than a fixed maturity date. There are many types of MBS. The simplest is called a pass-through participation certificate, where the principal and interest paid by the home buyer passes through to the MBS holder. Other, more complex structures are collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs). These more complex structures usually allow investors to buy specific slices or tranches of the mortgages to satisfy specific investment objectives. These subprime tranches were one of the major drivers of the 2008 financial meltdown. To determine value, you would need to model the probabilities of prepayments and defaults, which is complex, especially for retail investors. Luckily, rating agencies -- such as Standard & Poor's and Moody's -- came to the rescue and rated these MBSs, similar to the way they rated bonds.
There are over 20 closed-end funds (CEFs) and ETFs that invest primarily in MBS. To reduce the trade space, I selected candidates based on the following criteria:
- At least a three-year of history (MBS funds are relatively new so only a few have histories greater than three years)
- Market cap greater than $150 million
- Average trading volume greater than 50,000 shares per day.
The following four funds satisfied all of these conditions:
- BlackRock Income Trust (BKT). This CEF trades at a 13% discount (which is much lower than its average discount of 5%) and has a distribution rate of 7%. Over the past few months, about a third of the distribution has been return of capital, but this has come from undistributed net income so it is not destructive. The portfolio holds 158 securities, most of which are investment grade mortgages. It utilizes 30% leverage and has an expense ratio of 1%.
- Western Asset Mortgage Defined Opportunity (DMO). This CEF trades at a 7.9% discount, which is low compared to an average premium of 2% over the past year. The fund distributes 8.2%, with no return of capital. It holds 324 securities, spread between subprime and prime residential and commercial mortgages. About 90% of the holdings are below investment grade. The fund utilizes 30% leverage and has a high 1.9% expense ratio.
- Nuveen Mortgage Opportunity Term (JLS). This CEF currently sells at a discount of 10%, which is very low compared with the past-year average premium of 2%. The distribution is 8.1%, which does not include any return of capital. The fund has 167 holdings, primarily in non-agency residential mortgages and commercial mortgages. This fund was launched on Nov. 25, 2009, and has a limited term of 10 years, at which point all assets will be distributed to the shareholders of record. About 80% of the holdings are below investment grade (mostly rated B). The fund utilizes 26% leverage and has a relatively high expense ratio of 1.4%.
- iShares Barclay MBS Bond Fund (MBB). This ETF tracks the Barclay Capital U.S. MBS Index, which reflects the performance of investment-grade mortgage backed pass-through securities issued by GSEs. This fund yields a low 1.3%. The fund is invested primarily in agency 30-year and 15-year mortgages. The expense ratio is a very low 0.27%. Two other ETFs, SPDR Barclays Cap Mortgage Backed Bond (MBG) and the Vanguard Mortgage-Backed Securities Index (VMBS), were not included in the analysis since they track the same index as MBB.
Since MBS have many of the same attributes as bonds, I also included the following ETFs in the analysis for reference:
- iShares Barclays 7 to 10 Year Treasury Bond (IEF). This ETF tracks the performance of intermediate term treasury bonds and yields 1.7%.
- iShares Barclays 20+ Year Treasury Bond (TLT). This ETF tracks the performance of long term treasury bonds and yields 2.9%.
For another comparison, I included the following ETF that invests in mortgage real estate investment trusts (mREITs) rather than directly in mortgage-backed securities.
- iShares Mortgage Real Estate Capped (REM) tracks the FTSE NARREIT All Mortgage Capped Index. Mortgage REIT companies buy MBS, using borrowed funds, and achieve their return based on the interest rate spread between long-term mortgages rates and short-term interest rates. Mortgage REITs typically use high amounts of leverage between 600% and 1,000%. In good times this leverage allows the companies to generate extremely high distributions. This ETF distributes a breathtaking 14.4%.
To analyze the risks and return of MBS funds, I used the Smartfolio 3 program, using data over the past three years. The results are shown in Figure 1, which plots the rate of return in excess of the risk-free rate of return (called Excess Mu on the charts) against the historical volatility.
Click to enlarge images.
Figure 1. Risk Vs. Reward Over Past Three Years
As is evident from the figure, MBS funds had a wide range of returns and volatilities. MBB had an extremely low volatility, even lower than intermediate treasury bonds. However, the return was also low. On the other side of the ledger, DMO had excellent returns but at the cost of high volatility. Were the returns commensurate with the increased risk? To answer this question, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with TLT. If an asset is above the line, it has a higher Sharpe Ratio than TLT. Conversely, if an asset is below the line, the reward-to-risk is worse than TLT.
Some interesting observations are apparent from Figure 1. MBB had about the same risk-adjusted return as treasuries. DMO was by far the best performer, with a much higher return and less risk than TLT. JLS also had an excellent risk-adjusted return but not near as good as DMO. REM, despite its high yield, could not come close to either DMO or JLS in risk-adjusted return. REM also had the highest volatility of the group.
In addition to risk-adjusted returns, you may also want to assess if adding MBS funds to your portfolio provides diversification. To be "diversified," you would choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. Therefore, I calculated the pairwise correlations associated with these MBS funds. The results are shown in Figure 2.
Figure 2. Correlation Matrix Over Past Three Years
As you can see, none of the assets were highly correlated with each other or with treasuries. MBB had the highest correlation and that was only about 60% with treasuries. So, overall, mortgage-backed securities were excellent diversifiers.
The investment landscape has become murkier in the recent past. Since early this year, the fear of rising rates has taken its toll on MBS funds, causing prices to plunge. To get a more near-term view, I ran the analysis from the beginning of 2012 to the present, a little over 1.5 years. This data is presented in Figure 3. Only three of the funds -- DMO, JLS, and REM -- had positive returns over this period. Similar to the three-year data, JLS and DMO had by far the best absolute and risk-adjusted returns. REM also held up reasonably well.
Figure 3. Risk Vs. Reward Since January 2012
In summary, MBS funds can have a number of benefits as long as the risks are understood. The best performers in this class have been closed-end funds rather than ETFs. Granted, much of the outperformance of the CEFs has come from the use of leverage and lower grades of mortgage-backed securities, which can also magnify losses in a downturn. But so far, the MBS CEFs have continued to perform quite well. A large percentage of the price reduction has come from the fact that premiums have turned into discounts. The net asset values of these funds should stabilize, especially if the Fed postpones tapering until the economy improves. At the current discounts, I believe these CEFs are a buying opportunity. But make no mistake, these funds have relatively high volatility (about the same as long-term bonds) and if you decide to add them to your portfolio, they will need to be managed carefully.