With the u.s. real estate recovery in full swing, now seems like a good time to consider mortgage-backed securities. They offer attractive yields, solid credit fundamentals and diversification potential. Meet Ellie and Bob. Ellie and Bob are searching for a dynamic and innovative investment opportunity in this low interest rate environment, and mortgage bonds seem to be an attractive option for a variety of reasons.
But first we what our mortgage-backed securities? Mortgage backed security or MBS is an investment in a large pool of real estate loans. Thousands of individual mortgages are grouped together securitized and then sold to investors as bonds.
But simply mortgage bonds are like apple orchards and the mortgage loans are like apple trees. Thousands of individual trees are planted together checked for quality and then sold to investors. These orchards can be grouped into four different kinds of securities.
Agency MBS mortgage-backed securities are bonds backed by a pool of residential mortgages, issued by government-sponsored enterprises GSE, Fannie Mae Freddie Mac and Ginnie Mae. Today agency MBS market is one of the most liquid fixed income markets in the world with trading volumes typically in the trillions of dollars per year.
The securities are triple-a rated and because payments are guaranteed agency mortgage bonds provide almost the same stability as US Treasury bonds do, but with a slightly higher yield. In other words agency MBS are orchards of apple trees organized and looked after by one of three government-sponsored farmers. The quality control of Fannie Mae and Freddie Mac has never been more thorough, thanks to the GSEs guaranteed.
The agency orchards can provide a relatively reliable and healthy harvest for Ellie involved. Credit risk transfer securities or CRTs are mortgage related bonds issued by US housing agencies Fannie Mae and Freddie Mac. These bonds generally offer higher yields than agency MBS.
Because they are not guaranteed by the housing agencies but instead transfer a portion of the credit risk defaults of. These mortgage pools from Fannie Mae and Freddie Mac to the CRT investor. While an MBS can have either a fixed or floating rate. CRT securities are designed as floating rate securities tied to one month LIBOR.
So they tend to perform well in an environment of rising interest rates but simply CRT securities are bonds issued by Fannie Mae and Freddie Mac alongside their orchards which allow the farmers to sell some of their harvest risks, like some apples turning out bad to the investors.
But because Fannie Mae and Freddie Mac have very strict quality control over the apples and trees the risk of a very bad harvest is quite low. Each year CRTs are becoming more and more popular for investors like Ellie and Bob.
A non agency residential mortgage-backed security or RMBS is a legacy security that is not issued by a government-sponsored agency and was instead securitized and issued by private entities such as banks generally before 2008.
Unlike agency MBS our MBS divide no guarantee of principal or interest payments to investors, that they offer higher yields.the our MBS market has stabilized since 2010. Borrowers who are going to default have largely done so and bond prices currently reflect that wave of earlier defaults.
But because our MBS are hardly issued anymore after 2008, the market is shrinking every month the trees in the our MBS portraits are not of the same high quality as the Fannie Mae and Freddie Mac orchards.
But their lower prices also reflects this lower quality and so investors can still get a reasonable deal from buying these fruits like our MBS a commercial mortgage-backed security or C MBS is issued by a private financial institution without a guarantee of interest and principal payments.
But unlike our MBS a/c MBS is backed by mortgage loans on commercial real estate. Instead of residential real estate they finance properties such as offices ho shopping malls industrial buildings and multi-family housing.
In other words a CMBS is like a fruit plantation tended by a private company like an RMBS. but involves the planting of oranges instead of apples because oranges contain a different nutritional value than apples, they can offer better diversification and a more complete diet Elly and Bob.
The mortgage-backed securities market is a large multi trillion dollar bond market that provides diverse sources of income in both fixed and floating rate structures, to accrue better returns on their investments and the most plentiful harvests.
The wisest approach for Elly and Bob is the structure their investment portfolio with a balance of different fruity orchards on one hand agency MBS and high rated CMBS offer potential for a more secure investment for a recessionary market environment.
These are ideal orchards for a reliable harvest of apples in a cooler climate. on the other hand lower rated CMBS, non-agency MBS and CRTs offer a higher potential for income generation during an expansionary market. These are ideal orchards for a higher yield of apples you know warmer climate.
If Elly and Bob diversify their portfolio enough by balancing allocations to these different orchards, they can not only expect a more stable harvest in any environment, but also excellent risk and return dynamics.