Making Money In The Mortgage Market

 |  Includes: MBB
by: Efficient Alpha

By Joseph Hogue, CFA

A balance of fixed-income and equities is an absolute must for any long-term portfolio. Fixed-income, or bonds, usually return a strong income yield to investors and come at a lower risk level than stocks. The trade-off is that bonds do not enjoy the returns gained by stocks during bull markets and may see their prices fall when interest rates rise.

Despite the allure of stocks, as well as the focus afforded by the media, investors cannot afford to neglect putting a portion of their portfolio in bonds. An investment exclusively in the SPDR S&P500 (SPY) since 2007 would have returned an annualized 2.2% with 26% volatility. Combining the S&P500 with a 50% allocation to the iShares Barclays Aggregate Bond Fund (AGG) would have increased your return to 4.1% per year and lowered the portfolio volatility to 13.3% as well.

Granted, the last five years have seen incredible volatility and low returns. Had you looked at the portfolio over a different period, the results would be different. Unfortunately, unless you have a perfectly functioning crystal ball, you will not be able to time the market and must defer to rational portfolio construction which includes investment in bonds.

While most retail investors are still hesitant about investing directly in fixed-income issues, exchange-traded funds that allow diversified exposure to the space have become common. These funds are usually passively managed and charge a fee of around 0.3% per year. The funds trade like stocks and give investors the opportunity to diversify their fixed-income investment over a range of companies, bond types, and ratings.

Why the Mortgage Market?

The mortgage market and residential MBS products have gotten a bad reputation over the last few years and many investors attribute too much risk to the market. While many subprime instruments returned little to their investors, those investments backed by agencies like Fannie Mae and Freddie Mac were paid with an implicit guarantee by the government.

I wrote a previous article about mortgage REITs that helped to dispel some of the fears in the MBS and collateralized mortgage obligation (CMO) market. Not only are these investments relatively safe, but they also offer very good risk-adjusted returns. The massive amount of liquidity poured into the market by the Federal Reserve has driven yields down and concentrated much of the risk on the term structure. Because of this, investors are not being compensated for other kinds of risk, i.e. credit risk and market risk. CMOs and MBS are providing higher yields than other bond products because of the breakdown in prepayment models used to price the instruments.

Normally, MBS and CMOs are priced so that when investors are compensated for the risk of negative convexity. This is where the bond price does not increase as rapidly as other bonds in a falling rate environment because homeowners refinance the debt and the investor gets paid off sooner. Money received now instead of later may seem like a good idea, but when you have to reinvest it at lower rates it can mean lower cash flow than expected. Because of the housing crisis, many homeowners are not refinancing their mortgages even despite extremely low rates. This means that the owners of the MBS and CMO investments will still receive those high coupon interest payments for as long as the principal is outstanding.

CMO evaluator Udo Onwuachi summed it up for me in an interview, "CMO investments are increasingly being used for yield as real rates fall to zero on treasuries bringing other fixed-income products down as well. Unlike other securitized products, credit risk is not an issue with agency CMOs because the underlying pool of mortgages is insured for default by the agency government-sponsored enterprises (GSE). Different tranches within the CMO product include different levels of prepayment risk and an asymmetric risk-return profile, so usually offer higher yields than similar investments."

An MBS Bond Fund to Complement Your Portfolio

The iShares Barclays MBS Bond Fund (MBB) is a good entry into the mortgage-backed securities market. Like many bond funds, the shares trade like a stock and are passively managed charging only 0.25% annually. The fund invests at least 90% of assets in agency-backed, investment grade MBS pass through securities. It pays a distribution yield of 3.28% and has returned an additional 2.2% over the last 12-months.

The fund has tracked the overall bond market extremely closely since inception in 2007. Correlation with the Barclays Aggregate Bond Fund is 0.989 over the period meaning 97.8% of the variation in MBB can be explained by the AGG fund. The MBS fund has underperformed slightly by 0.09%, less than a tenth of a percent, over the period on an annualized basis but with less volatility. The aggregate bond fund shows an annualized volatility of 6.7% while the MBS fund only varies by 4.3% on an annualized basis. Investors in the MBS fund also enjoy a yield that is 47 basis points (0.47%) higher than the aggregate bond fund.

While investors should diversify their fixed-income investments to corporate and emerging market debt, agency-backed mortgage debt can provide a reliable source of income without credit risk. These funds can serve vary well as the safety-portion of your portfolio, protecting your nest egg from market risk and emergency needs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.