Mortgage-backed securities (MBS) are investments based on pools of home mortgages. Banks and mortgage companies sell mortgages to other companies. These groups then bundle the mortgages together. If you invest in MBS, you are buying a claim to the cash flow coming from these debts. You are in effect lending money to homeowners and getting back money in the form of their mortgage payments.
There are two types of mortgage-backed securities: agency or non-agency. Agency MBS are created by government or quasi-government agencies. Non-agency MBS are created by private entities. Learn more about agency and non-agency MBS. It can help you decide whether they have a place in your portfolio.
Definitions of Agency and Non-Agency MBS
Agency MBS are created by one of three agencies. These are Government National Mortgage Association (GNMA or Ginnie Mae), Federal National Mortgage (FNMA or Fannie Mae), and Federal Home Loan Mortgage Corp. (Freddie Mac). Securities issued by any of these three agencies are referred to as agency MBS.
Ginnie Mae bonds are backed by the full faith and credit of the U.S. government. They are thus free from default risk. Fannie Mae and Freddie Mac were both chartered by the U.S. government. But, they're now owned by shareholders. They work under a congressional charter. They lack the same backing as Ginnie Mae bonds. But, the risk of default is still fairly low.
Private entities, such as banks, can also issue mortgage-backed securities. In this case, the MBS are referred to as non-agency MBS or private-label securities. These bonds are not guaranteed by the U.S. government or any government-sponsored enterprise. Non-agency MBS are often based on pools of borrowers who couldn’t meet agency standards.
Many of these non-agency loans were the “Alt-A” and “subprime” loans that fueled the 2008 financial crisis. This, plus the lack of government backing, means that non-agency MBS contains credit risk not present in agency MBS. In other words, there is a higher chance of default on these bonds.
A Brief History of Non-Agency MBS
Non-agency MBS were most heavily issued from 2001 through 2007. This came to an end in 2008 after the mortgage crisis in the U.S.
The rapid growth in the non-agency MBS market is widely cited as being a key factor in the crisis. This is because these securities provided a way for less creditworthy buyers to gain financing. Over time, it led to an increase in delinquencies.
The result was that non-agency MBS collapsed in value in 2008. The issue quickly spread to higher-quality securities. This sped up the crisis. Banks and other groups stopped issuing non-agency MBS for years.
Starting in 2015, a few hedge funds and private-equity firms began issuing new non-agency MBS. In 2016, Lone Star Funds issued the first non-agency MBS that were backed by mortgages originated after the crisis and rated by credit rating agencies.
Money managers can still invest in pre-crisis non-agency MBS today. This is because the securities issued prior to the crisis still trade in the open market. The asset class has done very well in the recovery. This has rewarded money managers who took the risk of buying into a very depressed market in 2009.
The Bottom Line
Except in the rarest of cases, non-agency MBS are not for individual investors. While the upside on these investments can be high, they also come with a high amount of risk. It is also hard to predict what future risk will be—especially in the housing market.
But, many actively managed bond funds own these securities. Much of the time, the funds have owned these bonds since the post-crisis period. In this case, they would have given returns a large boost.
While there isn’t nearly as much upside in non-agency MBS now as there was a few years ago, you may think of their presence in a bond fund as a sign. It says that the manager is willing to seek opportunities in unpopular market segments. Whether that is the right choice for you will depend on your goals and risk tolerance.
Frequently Asked Questions (FAQs)
Why should I buy mortgage-backed securities?
In general, investing in MBS can provide a steady cash flow with higher yields than Treasury bonds. They also offer an opportunity for geographic diversification in your portfolio.
Where can I buy mortgage-backed securities?
You can purchase mortgage-backed securities directly through a bank or broker or as part of a mutual fund or exchange-traded fund.
How are mortgage-backed securities priced?
Pricing mortgage-backed securities is a complex task that involves many predictions and assumptions about the potential for homeowners to prepay or refinance their mortgages in conjunction with changing interest rates. Investors should understand the role these assumptions play before purchasing MBS for their portfolio.