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Investing for Income in MBSsReaching for Yield in Mortgage-Backed Securities
Despite recent headlines on the much maligned mortgage market and credit crunch the vast majority of mortgages are fine and can produce a steady stream of monthly income.
The majority of the bad news reported is about "sub-prime" or poor credit quality loans and "teaser rate" mortgages that are now re-pricing at prevailing interest rates that people cannot afford. Having said that, there is a list of caveats and "what-if’s" an investor should be aware of even on normal mortgage-backed-securities before participating in this portion of the fixed-income market. How Mortgage-Backed Securities WorkA mortgage-backed security is actually a pool of everyday loans that are securitized through a government agency such as "Fannie Mae," "Ginny Mae" or "Freddie Mac." These agencies guarantee the timely payment of principal and interest and the originating lender keeps ¼% to ½% as a servicing fee. These securities are then sold through dealers to the end investors. Every month the security pays the investor principal and interest. The upshot of that is if the investor spends the principal, that money will never be available for reinvestment. The principal portion is "par" dollars, so if the investor paid 102 for an MBS, every dollar of principal that is paid back is an automatic 2% loss. The opposite is true of an MBS at a discount. What Are the Risks in a Mortgage-Backed Security?Most mortgages are 30 years. An MBS pays monthly principal and interest; the resulting cash flow causes the MBS to have what is called an "average life." Principal paid back is known as the "pre-payment" rate. On a brand new MBS, that average life is usually 12 years. This is a major caveat in the secondary market because that average life is dynamic – not static. It can and does change. The tongue-in-cheek expression in the investment community is known as "mortgage magic." This is accomplished by assuming a faster or slower pre-payment rate. This assumption has the result of changing the average life and thus the yield to the investor. These assumptions can be justified by increasing defaults, various parts of the country, economic conditions and so forth. Who is to say these assumptions are wrong? Pre-payment Assumptions CompoundedSuppose an investor bought a new MBS at what is a normal 6% pre-payment rate, 12-year average life and paid a small premium for it. Then defaults increase and/or people start selling their homes faster and the pre-payment jumps to 10%. The increased principal that comes back is at par so the resulting yield is lower as is the market value of the MBS. Some Advice on Mortgage-Backed SecuritiesAside from substantial the mark-up in prices (often 2% to 3%) to retail investors, you can no doubt see that this portion of the fixed-income market is as much an art form as it is a science. To be candid, a retail investor should seek out a professionally managed fund of MBSs should they care to participate in this segment of the fixed-income market. The Seventh Deadly Sin is Greed. When people become dissatisfied with the income on their fixed-income investments, they often start to reach for more in mortgage backed securities. Don’t get in over your head; let professional asset managers handle it.
The copyright of the article Investing for Income in MBSs in Bonds is owned by Dean Lundell. Permission to republish Investing for Income in MBSs in print or online must be granted by the author in writing.
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