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By Christine Benz and Eric Jacobson | 04-25-2012 02:00 PM

An Investor's Blueprint for Mortgage-Backed Bonds

Morningstar's Eric Jacobson outlines the fundamentals and key risk factors investors should know about this huge part of the bond market.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Mortgage-backed bonds make up a huge percentage of the bond market, but they may be less familiar to bond-fund investors than corporate bonds or Treasuries. Joining me to discuss these securities is Eric Jacobson. He is director of fixed-income analysis with Morningstar. Eric, thank you so much for being here.

Eric Jacobson: I am glad to be with you, Christine.

Benz: Eric, let’s start by just giving people a basic overview of these bonds and the logistics of how they work.

Jacobson: Sure. Well the key thing to understand is that mortgage-backed securities, as we call them really, are collections of mortgages that are typically pooled together and bundled into securities. And the thing to understand is that they can run the gamut in terms of complexity, depending on how you slice and dice those securities once you create them. That’s one of the reasons why, as you suggested, people may not be as familiar with them because the way this market works tends to be very targeted toward institutions.

Benz:  So Eric, what are the key flavors of mortgage-backed securities that investors should be aware of?

Jacobson: Well the largest chunks of the market are going to be mortgages that are backed in one way or another by the government. So historically we would be talking about Ginnie Mae mortgages, as well as Fannie Mae and Freddie Mac, which were essentially assumed to be backed by the government. Nowadays, the way that things have gone ever since the financial crisis, Fannie Mae and Freddie Mac mortgages are even more explicitly backed in some ways than they used to be.

But essentially you are talking about these three agencies forming the bulk of issuance now in the mortgage market. There are still outstanding a lot of mortgages that were issued and created that were never bundled up and guaranteed by those agencies that were essentially structured in different ways to provide security. People may remember that’s a big part of the market that blew up during the crisis, but there is a lot of that stuff still outstanding. You don’t find it in that many mutual funds, but those that buy it find a lot of opportunity there because of the fact that demand has been so low for that section of the market.

Benz: So in general that part of the mortgage-backed security market that is not backed either implicitly or explicitly by the government, that’s the riskier piece, generally speaking, even though I am sure managers would argue that there are higher quality securities within that grouping?

Jacobson: Exactly. I think, the underlying collateral is from the types of loans that ran into trouble most during the crisis. As you say managers will argue today that because their prices are so depressed and they are essentially being marked at fire-sale levels, they are actually not that dangerous, which is a pretty compelling argument. But the fact of the matter is that because they are not government-backed and guaranteed, for those kinds of reasons you don’t find them in the core sections of most portfolios today.

Benz: So let’s talk about the pervasiveness of these bonds in bond-fund portfolios. Obviously there are funds that are specifically named Mortgage-Backed Securities that have a specific targeted focus on this sector. But how about within the typical, say, intermediate-term bond fund, how big a role do mortgage-backed securities typically play?

Jacobson: Unless a manager has a particular focus most will have a decent-sized portion of their portfolio in mortgage-backed securities, if for no other reason than that they don’t want to diverge too much from the Barclays U.S. Aggregate Bond Index, which despite all the name changes is still sort of the lodestar for the bond-fund market.

Benz: Another grouping that I'd like to look specifically at would be the Ginnie Mae-focused funds. A lot of investors have a lot of money in these funds. Vanguard's Ginnie Mae fund is one of the biggest out there. This has really been a tremendously performing fund, a great asset class overall. I'm wondering if you could discuss what has helped returns in the past and also any risk factors that investors should have on their radar.

Jacobson: Well, the one thing that has helped the most in the last year in particular, when you go back to 2011, is that the quality is so high because they are explicitly backed by the U.S. government that, Ginnie Mae mortgages did even much better than Fannie and Freddie Mac mortgages during the rally last summer. And for the year as a whole, they looked a lot better in returns. And part of the reason was, I think, that there were questions about different kinds of programs that might affect Fannie Mae and Freddie Mac and might drive up prepayments a little faster than the market was expecting, so they lagged a little bit partly for that reason. 

But by and large as I said, because of their relationship to Treasuries, having such high quality and having that extra bit of income that's associated with the option for investors to prepay, and because of that option for investors to prepay their mortgages, that's why mortgages tend to yield more than Treasury bonds. But you bake all that together, and they did really well last year.

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