Connect ► twitter| youtube|  Log In ► Members Only  |  Corporate One Safekeeping  |  Search

Investment Strategies: Why Mortgage-Backed Securities may benefit your credit union right now

By Jeff Duesler, Senior Investment Services Representative

2020 Third Quarter Economic Update

Now available on-demand

Recent trends in the markets, which include excess liquidity at financial institutions, have made investors pivot from certificates of deposit into different securities types, such as mortgage-backed securities. The mortgage-backed securities market is the largest (cash) fixed-income market. In simple terms, mortgage securities are bonds created by selling real estate loans to Fannie Mae, Freddie Mac, and Ginnie Mae; these agencies then package the loans together and sell them as securities to investors. The principal and interest on the securities is guaranteed by Fannie Mae and Freddie Mac.

For credit union investors, mortgage securities come in two forms: Pass-Through Securities (also known generically as MBS) and Collateralized Mortgage Obligations (CMOs). The primary benefits of these securities include the following:

  • They offer monthly cash flows in the payment of both interest and principal.
  • They may offer additional yield (return) over certificates of deposit, treasuries, and U.S. government agency debentures without taking on credit risk.
  • They allow participation in the residential real estate market with opportunities for both geographic and socio-economic diversification.
  • They provide good liquidity and can be used as collateral at most liquidity providers.
  • With CMOs, investors can target structures best suited for the overall cash-flow distribution in the portfolio.

Today’s article offers an introduction (or reintroduction) to both types of securities and reviews the overall market for each.

Pass-Through Securities (or MBS)

These are the most basic of the mortgage securities and are created by pooling together loans with similar characteristics and securitizing.

  • They have stated final maturities at issuance of 30yr, 20yr, 15yr, and 10yr. The coupon rates on new issue pools are set monthly and are currently trading at 1.50%, 2.00%, 2.50%, 3.00% and 3.50%. Each loan in the pool is unique, and each borrower could be paying a different rate on their mortgage. The difference between the coupon rate paid to the investor on the pool and the individual rates on the loan in the pool is the servicing spread and the fee that the agency receives for guaranteeing the loan.
  • Each investor that purchases these securities has undivided ownership interest and is entitled to a share of principal and interest payments according to the original face amount purchased. The trustee calculates and passes on the interest and principal payments monthly to the individual investors.
  • These payments are guaranteed by the individual agency that “backs” the security, so if borrowers get in trouble, the payments would be picked up by the agency. As the loan continues to be impaired, the agency can decide to pull the entire loan out of the pool.

Collateralized Mortgage-Backed Securities (CMOs)

CMOs have had a bit of a public relations problem, especially following the financial crisis, as they took the stage right next to Collateralized Debt Obligations (CDOs) and credit default swaps as securities that brought down the markets. While this may be true of private-label CMOs, it was less true for agency-backed CMOs that are appropriate for credit unions. CMOs are also known as “derivatives,” which doesn’t help the situation; however, they are called derivatives because they are created by taking attributes of one or more pass-throughs to create a more predictable stream of cash flows.

  • CMOs organize principal payment according to final maturities and different classes based on risk. Meaning, different classes or “tranches” are created in order to absorb prepayment volatility.
    • Example: If there was market demand for a bond that would have an average life of five years, a dealer will create a structure based on prepayment assumptions that would allow that bond to have the targeted average life. For this to happen, there must be other classes/structures within the CMO structure that would absorb additional prepayments.
  • The classes/tranches that absorb the variability of principal payments are riskier, and investors who purchase these classes enjoy more yield. This is commensurate with the additional risk they are taking. The less risky classes are those that are appropriate for our purposes as investors for the credit union.
  • CMOs were originally created so the less-risky part of the security could most resemble a bullet security. All types of investors can benefit from this, but at first it was meant to attract institutions like insurance companies and money management firms that were used to the certainty of payment from investments like corporate bonds.
  • Like Pass-Through Securities, during the period when a principal payment window is open, investors receive both principal and interest payments. By design, an investor might choose to purchase a bond that isn’t receiving principal payments just yet; this is known as the “lockout period” where you would just receive interest.

The following chart indicates the differences in yield between pass-through issues and corresponding U.S. Treasuries and Agency Bullets. As indicated, there is a significant pick up in yield.

Security TYPE US Treasury Agency Bullet 15Yr Pass Through 20Yr Pass Through
Maturity/Avg Life 4.0Yr 4.0Yr 4.0Yr 4.2Yr
Yield 0.200% 0.200% 0.96% 1.11%

*Pass-throughs quoted using 2.00% coupon rates.

Risks to consider

You often hear in the investment world that “there’s no free lunch.” While this phrase might sound harsh, especially when referring to mortgage securities, it doesn’t detract from the merits of this particular investment type. In fact, considering some potential risks might explain the reason for earning some of the additional yield over U.S. Treasuries. Most of the risks are dependent on the speed in which homeowners pay off their loans and include:

  • Variable cash flows, which could make budgeting for investment income more challenging.
  • Prepayment risk, which occurs when a pool or a CMO prepays faster than expected. This is most concerning when a premium is paid for the security, eroding some or all of the security’s return.
  • Extension risk, which is the opposite of prepayment risk and occurs when the bond prepays slower than anticipated and the average life extends out longer than expected.
  • Lack of a guarantee that these will perform exactly as planned, which is because CMOs are “structured” and are created based on certain prepayment assumptions. (Terms are available to the investor through an offering circular or prospectus.)
  • Prepayment speeds, which determine how attractive/unattractive an offering is. Mortgage securities rely on estimates of prepayment speeds that could change over time.

Risk mitigation

While risks are inherent in these types of securities, and not all risks can be eliminated, there are tools available for pre-purchase analysis to help your credit union with its due diligence. The best tools to use are your broker(s) and their access to Bloomberg (the most widely held/used tool) and/or a bond analytics program. Some examples of these analytical tools include but aren’t limited to the following:

  • Vectoring/scenario analysis: Running the bond at different prepayment speeds for different periods of time will offer a look at how these different prepay scenarios affect the bond’s attributes.
  • Setting a limit on price and weighted average life volatility: The traditional FFEIC or FMED test usually takes care of this; however, establish your own parameters. A bond will “pass” this test if the weighted average life doesn’t extend past four years when interest rates are increased by 300 basis points and the price isn’t reduced by more than 17% during this same scenario.
  • Setting parameters and analyzing the composition of the underlying collateral: For example, limit the percentage concentration in one geographic location or concentration of one third-party originator.
  • Using multiple prepayment scenarios: Bloomberg offers multiple prepay models. Most popular are the “dealer consensus model” (default model) and the BAM model (Bloomberg Agency Mortgage Model). If the bond or collateral is “seasoned” or has been trading, you could look at historical models to get an idea of how the prepayments have acted. You could also “shock” or ramp up the bond using prepay speeds that escalate quickly; this is useful in seeing at what speeds the bond might turn to a negative yield.

What’s next?

Corporate One has five fully licensed investment professionals on staff that will assist with any questions you might have. We recommend working with your investment professional to execute the right strategy for your credit union and tracking the market by collecting data and mortgage offerings from different sources: your Corporate One senior investment service representative and other brokers. Feel free to reach out to us directly at 800/366-2677.