In today’s world of historically low interest rates, achieving a positive inflation-adjusted return is challenging. Specifically, investors would need to find at least a 2% nominal return just to exceed the Federal Reserve’s inflation target. Among U.S. Treasuries, a 2% yield has recently been available only on bonds having maturities longer than 10 years. However, Treasuries of such long maturity can have substantial interest-rate risk. While venturing into the credit market can help investors meet their return needs, they risk losing some of their principal.
Mortgage-backed securities (MBSs) guaranteed by the Government National Mortgage Association—GNMAs—can offer a compelling alternative.1 The most basic and common MBS is a pass-through, which “passes through” to investors the monthly principal and interest payments from a pool of U.S. residential mortgage loans.2
Understanding different types of MBS
GNMAs, in particular, are backed by pools of first-lien mortgage loans insured or guaranteed by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the Rural Housing Service (RHS).3 The borrowers associated with these loans are typically first-time homebuyers, have a low to medium income profile, and can afford only a small down payment—5% or less.
GNMAs are the only MBSs for which the government guarantees full and timely payment of principal and interest.4 This guarantee gives GNMAs the same credit quality as U.S. Treasuries. Fannie Mae (FNMA) and Freddie Mac (FHLMC) are two government-sponsored enterprises (GSEs) that issue MBSs, but these MBSs do not have an explicit government guarantee, only a strongly implicit one.5
Collectively, the MBSs backed by GNMA, FNMA, and FHLMC are known as Agency MBSs. The Agency MBS market has more than $5 trillion outstanding, second only to the U.S. Treasury market in size, depth, and liquidity.
Private-label residential MBSs (RMBSs) are completely distinct from Agency MBSs. While the latter get their credit support from the government guarantee (within the limitations stated above for FNMA and FHLMC), the former get their credit support primarily through senior/subordinate bond structures. The private-label RMBS sector is the part of the MBS market that suffered the most from the collapse of the housing bubble, and since the financial crisis of 2008, there has been virtually no new private-label issuance. At this point, most of the legacy securities originated in the years leading up to the crisis have been downgraded to junk status.
Government guarantee does not mean risk free
Like virtually all bonds, GNMAs have interest-rate risk—as interest rates rise, GNMA prices tend to fall, and as interest rates fall, GNMA prices tend to rise. The chart to the right illustrates the price volatility of a representative 4% GNMA pass-through security backed by 30-year fixed-rate loans. The price of this security varied within a $14 range from February 2010 to February 2012.
Duration is a useful way to quantify a bond’s interest-rate risk. Roughly, duration equals the percentage change in the value of a bond for a one percentage point change in interest rates. So, as duration increases, so does price volatility. For example, the duration of 5-year and 10-year Treasury notes, for which the principal payment at maturity is by far the most significant cash flow, is about 4.8 and nine years, respectively. By comparison, the duration of a newly issued, par-priced 30-year GNMA pass-through is about seven years. The Barclays GNMA Index typically has a duration between four and five years, and this duration has ranged between two and six years since 2003.
Higher yields than Treasuries help compensate for prepayment risk
One of the appeals of GNMA MBSs is that they typically outyield comparable-duration Treasuries by 100 basis points or more (see chart below, right).
Importantly, the MBS yield advantage is not free. Rather, a significant portion of it is compensation for prepayment risk—most U.S. residential mortgages can be prepaid in part or whole at any time. In the context of GNMAs, there are three main sources of prepayments:
- Sale of home. A home sale typically leads to the associated mortgage being paid off.6 Housing turnover is the dominant source of prepayments in MBSs in which the borrowers are paying a rate below prevailing mortgage rates.
- Refinancing of loan. Borrowers refinance either to obtain a lower interest rate or to cash out some home equity, or for both reasons. Refinancing activity represents the most volatile component of prepayment speeds, and constitutes the dominant source of prepayments in MBSs.
- Buyout of seriously delinquent loans. Loan servicers of GNMA pools have the ability to buy seriously delinquent loans at par from GNMA pools.7
The option to prepay is valuable to borrowers.8 When rates fall, borrowers can refinance into a new mortgage that has a lower rate. On the other hand, when rates rise, borrowers can stay put in their existing mortgage, which then bears a below-market rate.
Since the prepayment option is valuable to borrowers, it must work to the detriment of MBS investors. Specifically, when rates fall, refinancing activity increases, and thus MBS holders get more prepaid principal and face reinvesting at lower yields. Similarly, when interest rates rise, refinancing activity slows, and MBS holders get less prepaid principal when they would most like to reinvest at higher yields.
There is another, less broadly discussed aspect to prepayment risk. Specifically, unlike other callable bonds where the option is exercised efficiently, the relationship between interest rates and prepayments is messy and inexact. Prepayment behavior depends on the collective decision making of thousands of individual borrowers evaluating the dollar value of the incentive to refinance or relocate given the prevailing lending environment. Thus, even if investors knew the future path of interest rates, the pace of prepayments would still be uncertain.
As a vivid illustration of how this uncertainty can affect investment returns, consider an MBS priced at $110. Suppose that one day all the borrowers in the pool get a solicitation from their lender to refinance. If by chance they all take advantage of this opportunity, then investors will get their principal back at $100 per security, for an immediate $10 loss. In practice, prepayment surprises are rarely this dramatic, and surprises do not always lead to a loss. For example, in the aftermath of the financial crisis, lending standards tightened dramatically, and so prepayment speeds were slower than had been expected on securities priced above $100, which worked to the benefit of investors. In general, for securities priced above $100, surprisingly fast speeds have hurt returns and surprisingly slow speeds have helped them; conversely, for securities priced below $100, surprisingly slow speeds have hurt and surprisingly fast speeds have helped. This effect grows as the MBS price moves further from $100 in either direction.
Historically, the incremental yield offered by GNMAs over Treasuries has more than compensated for the prepayment risk. For example, for the period from 1992 to 2012, the Barclays GNMA Index outperformed duration-matched Treasuries by an average of 0.35% per year.9
Opportunities for active management
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In spite of the GNMA MBS market’s size and depth, it is not nearly as efficient as the Treasury market. Skilled portfolio managers, supported by diligent research, trading, and risk controls, have the potential to outperform the Barclays GNMA benchmark.
These opportunities arise for several reasons. First, the market is diverse, comprising more than 200,000 securities, each having its own characteristics. Second, prepayment behavior is challenging to model and predict. Third, there are large institutional investors who do not devote the necessary resources to careful security selection; their inattention to detail leaves greater opportunity for other investors. Finally, the market trades over the counter, making continual market surveillance for price discovery and constant monitoring of supply and demand indicators critical.
GNMAs offer a high-quality bond alternative to Treasuries. They have a higher yield than U.S. Treasuries as compensation mainly for prepayment risk. Given the size and complexity of the market, I believe there are many opportunities for an active manager to outperform the GNMA benchmark. Specifically, in my view, security selection supported by careful research, trading, and risk controls can frequently identify investment opportunities. For most investors, I believe a professionally managed and diversified portfolio can be the most effective way to get exposure to the MBS asset class.