Many investors don’t understand the nuances and intricacies of mortgage-backed securities (MBS). Consequently, few can appreciate the role of institutional MBS investors in the recent bond market rout. Instead of complaining about recent bond losses, our time is better spent exploring the machinations of MBS investors to help gauge where returns might go.
This somewhat wonky article explores the unique qualities that set MBS apart from other types of bonds. Importantly, these characteristics help us appreciate the contribution of MBS investors to the recent surge in yields. Furthermore, it should also give bond investors optimism that a good opportunity is approaching with a large group of bond sellers on the sidelines.
MBS are bonds secured by individual mortgages with similar characteristics. The chart below from SIFMA shows that MBS are the second largest fixed income security behind US Treasuries.
The prepayment option attached to the underlying mortgages distinguishes MBS from other bonds. A mortgagee can repay part or all of their remaining balance at any time and for no reason. In addition, mortgages pay a small amount of monthly capital. These characteristics make investing in MBS difficult but rewarding.
Adding to the complexity of MBSs, the timing of mortgage prepayments is not solely a function of the level of interest rates. For many reasons, individuals do not refinance their mortgages when interest rates suggest it.
Due to its unique and less predictable prepayment option, the cash flows of MBS are markedly different from those of other bonds. When mortgage rates are very low, many mortgagees pay off their loans through attractive refinancing options. Additionally, low mortgage rates encourage more real estate transactions, leading to mortgage prepayments as mortgagees sell their existing homes and pay off their loans. In low rate environments, the expected lifetime of an MBS is considerably shorter than in a higher rate environment.
Duration and convexity
In bond market parlance, the life of a bond is the duration. Duration measures how long it will take an investor to be repaid by the cash flows of a bond. Duration is also a measure of the bond’s price sensitivity to changes in its yield. For example, a duration of 5 means that if yields increase by 1%, the price of the bond will fall by 5%.
The chart below from Raymond James shows how sensitive bond prices are to changes in yields as a bond’s duration increases.
As if the variable duration of an MBS were not enough to manage, the rate of change of its duration is not linear. In other words, as the duration changes, the price may fall even more or rise less than expected, given its original duration. Investors refer to the non-linearity of MBS duration as convexity.
When interest rates fall, the prices of MBS rise less than those of a bond without prepayment options, because the expected term of the mortgage becomes shorter. Conversely, when interest rates rise, the price of MBS may fall by more than non-callable bonds, as the expected maturity of the mortgage lengthens. Both are examples of negative convexity.
With a basic understanding of duration, convexity and its unique yield structure of MBS, let’s focus on the most important mortgage investors.
The Fed currently holds $2.7 trillion in MBS, less than a quarter of the $12.2 trillion in MBS outstanding. Of the MBS in circulation to the public, GSEs (Fannie Mae and Freddie Mac) and commercial banks hold most of the remainder.
GSEs and banks borrow money to acquire MBS. As such, they must constantly hedge to avoid significant mismatches between mortgage assets and loan liabilities.
For example, if a bank buys an MBS with a five-year term and funds it by issuing a five-year CD, they are term neutral. As long as the duration remains five, the bank should benefit as it had initially expected from the yield differential between MBS and CD.
Unfortunately for our bank, returns are constantly changing. Therefore, the duration is constantly changing. For example, if yields increase significantly, the duration of an MBS will increase, but the CD will still have a five-year duration which will predictably shorten over time. In this case, the MBS investor has a duration mismatch. The price of the mortgage will fall more than the theoretical price of the CD. In this case, the MBS investor will lose money due to the mismatch. Given the nature of leverage, the gains or losses are much larger than the difference between the MBS yield and the CD rate.
MBS investors use interest rate swaps, short US Treasury bonds/futures and options to manage duration. These instruments effectively adjust the term of the mortgage. The critical point is that these instruments ultimately result in the sale of US Treasuries when the duration of the mortgages lengthens and their purchase when it decreases.
The rise in interest rates
As mortgage rates climbed 4% over the past year, banks and GSEs were forced to aggressively hedge their rapidly widening term mismatches. They shorted US Treasuries, directly and indirectly, fueling the rise in yields. MBS legend Harley Bassman calls this type of convexity vortex feedback loop. Essentially, increased hedging needs lead to higher returns, which leads to more hedging and higher returns.
Mortgage terms are maximized
With an explanation of a critical factor behind this year’s bond rout, we share a silver lining.
Hardly anyone refinances mortgages at today’s prevailing mortgage rates. In addition, the number of home sales is dropping rapidly. As a result, MBS prepayments are minimal and MBS terms are almost fully extended. Even if yields continue to rise, MBS durations should only go up. As a result, the hedging needs of banks and GSEs to protect against higher durations will be minimal.
The chart above estimates the amount of ten-year Treasury bills an MBS investor would need to hedge compared to a year ago. According to Goldman Sachs, a year ago a 0.25% increase in yields forced banks and GSEs to conduct roughly $200 billion in hedging activity (short bonds). Today, a 0.25% move requires about a tenth of that amount.
Institutional mortgage investors are no longer the bond market’s problem. Importantly, when yields fall, they will need to exit their hedges. Ultimately, these collective actions will help drive yields lower, reversing the recent sharp rise in yields.
MBS hedgers are certainly not the only investors to blame for the recent surge in yields. But they are an important and well-known commodity.
Bond yields may continue to rise, but we are confident that a major yield influencer has finished selling. Additionally, if and when bond yields begin to decline, these same investors will need to hedge in the opposite direction. MBS vortices work both ways. Soon, mortgage brokers may be scrambling to buy bonds.
The author or his company may have positions in the titles mentioned at the time of publication. Any opinions expressed herein are solely those of the author and in no way represent the views or opinions of any other person or entity.