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Diversification in Mortgage Backed Securities

by Brian Schaff

We believe Mortgage Backed Securities (MBS) have a place in every bank portfolio. There are three categories of MBS included in this piece, that when added together, can work to create appropriate balance. In this month’s Pro Shop, we will examine plain vanilla fixed rate pools, adjustable rate mortgage (ARM) pools and Fannie Mae Delegated Underwriting & Servicing (DUS)/Freddie Mac Participation Certificates (PC). In addition to taking a look at the different structures, we will evaluate how does each one can fit into a comprehensive strategy in our current market environment?

Fixed rate pass through pools are the most common type of MBS. Monthly cash flow of principal and interest payments to offset bullet like structures, supplementing cash flow and allowing for reinvestment. Having a blend of final maturities and coupons can mitigate extension risk if rates drift higher and the effect of prepayments if rates fall. Higher coupons, while more attractive on a spread basis, will be the first to pay down should rates fall.
  • In this market: Look for discounts to slight premiums, blend coupons to diversify exposure. Keep premiums under 103 dollar price. Prefer 30 year pools which offer the most spread in liquid markets, especially 4-5% coupons that are at or near full extension.
Like fixed rate pools, ARMs provide monthly cash flow of principal and interest. They also have a set coupon for a fixed period, but the coupon will reset. Coupon resets are generally based off a Treasury rate or SOFR rate plus a spread. Keep an eye on the cap structure to determine the upside and downside risk of the pool. A 1/1/5 structure will have a 1% maximum move up or down on the first reset, followed by a 1% maximum move up or down on following resets, and a 5% maximum move from the initial coupon over the life of the bond. Another component is the secondary market liquidity of post-reset ARMs has strengthened considerably this year.
  • In this market: Look for favorable cap structures that will outperform (reset slower than benchmark rates) if rates fall such as GNMA 1/1/5 or longer reset 7-10 year new issue Fannie Mae or Freddie Mac for market coupons (5% or higher). Can act as a hedge against higher rates while providing current yield.
The last category includes two types of bonds that have nearly identical characteristics. Fannie Mae DUS and Freddie Mac PC bonds can be floating rate, but are typically fixed rate (over 90% of total issuance). They feature a balloon payment structure, creating yield lockout protected by either yield maintenance or other prepayment penalties. Often times backed by single loan multifamily collateral, there is no extension risk and more predictable cash flow than single family MBS pools. Shown in the table below, there are two yields- one at the front end of the regular payment window (100 CPY) and one at final maturity (0 CPY).
  • In this market: Be comfortable with yield/spread at both 100 and 0 CPY. Know the prepayment penalties and how they work. In the case of a prepayment scenario, DUS/PC purchased at a deep discount could be advantageous to the investor.

Combining the different structures of mortgage backed securities is a sound way to cover all market scenarios without straying from your interest rate bias. If you believe rates could be headed lower, there are strategies that can be employed without “putting all your eggs in one basket”. Contact your Country Club Bank representative to discuss building a balanced and sustainable portfolio utilizing these tools.
 


This information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.

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