Trading Mortgage Backed Securities (MBS)

MBS are essentially bonds backed by pools of mortgages.

When homeowners make their mortgage payments, those payments flow through to the MBS investors.

This offers investors a way to participate in the real estate market without directly owning properties.

For traders, they offer a different type of fixed-income product to trade.

Key Takeaways – Trading Mortgage Backed Securities (MBS)

• Interest Rate and Prepayment Sensitivity
  • MBS prices are influenced by interest rate changes and homeowners’ prepayment behaviors. This affects yields and requires active management to reduce risks.
• Credit Quality and Issuer Impact
  • The safety and return of MBS vary with the credit quality of the underlying mortgages and the backing (government or private issuer), which influences risk and yield profiles.
• Trading Complexity and Liquidity
  • MBS trading involves understanding complex structures like CMOs and assessing market liquidity.
  • Best for sophisticated traders/investors with a deep knowledge of fixed-income markets.
• MBS Strategy Types
  • Carry Trade
  • Relative Value Trading
  • Hedging
  • Option-Adjusted Spread (OAS) Analysis
  • Mortgage Basis Trading
  • Trading Volatility
  • Interest-Only (IO) and Principal-Only (PO) Strips
  • In-Depth Prepayment Analysis

Issuers

MBS can be issued by:

• Government-Sponsored Enterprises (GSEs) – Fannie Mae, Freddie Mac, and Ginnie Mae. GSE-issued MBS carry an implicit government backing, which reduces risk.
• Private Institutions – Banks and financial institutions package mortgages into MBS, but these are considered slightly riskier as they lack direct government guarantees.

How to Trade MBS

Individual MBS

You can buy and sell individual MBS through a broker.

But this requires considerable research and understanding of specific MBS characteristics.

MBS ETFs

Exchange-traded funds (ETFs) provide a simpler way to gain exposure to a basket of MBS.

They offer diversification and are more accessible for the average investor.

The most popular MBS ETF is under the ticker MBB (iShares MBS ETF).

Types of MBS

Agency MBS

Issued by GSEs.

Considered the safest.

Non-Agency MBS

Issued by private institutions.

Offer the potential for a higher yield but carry more credit risk.

CMO (Collateralized Mortgage Obligation)

A complex type of MBS where the underlying mortgage pool is divided into tranches with varying maturities and risk levels.

Core MBS Trading Strategies

Here are several common MBS trading strategies that traders use.

The suitability of a particular strategy depends on your risk tolerance, market outlook, and trading/investment objectives.

Carry Trade

The simplest strategy, it involves buying an MBS and holding it to collect the coupon payments (i.e., the interest earned).

The success of this strategy depends on:

• Interest rates staying stable or falling.
• Prepayments remaining within expectations.

Relative Value Trading

Tries to exploit price discrepancies between different MBS pools or between MBS and other fixed-income securities.

For example:

• Identifying mispriced MBS relative to other similar MBS.
• Trading the spread between MBS and Treasury bonds based on expectations about how that spread might change.

Hedging

Involves using derivatives (e.g., interest rate swaps, futures contracts) to offset risks within an MBS position.

For instance:

• Hedging interest rate risk by shorting Treasury futures
• Hedging prepayment risk using options strategies

More Complex MBS Trading Strategies

Option-Adjusted Spread (OAS) Analysis

Incorporates the value of embedded options within an MBS (e.g., the prepayment option) to make more informed trading decisions.

This helps determine the true “yield advantage” of an MBS.

Mortgage Basis Trading

Exploiting pricing differences between individual MBS and TBA (To-Be-Announced) MBS contracts.

TBA contracts represent generic MBS pools and can be used as a hedge (discussed more later).

Trading Volatility

Some traders focus on profiting from changes in MBS volatility by using tools like options and futures.

Interest-Only (IO) and Principal-Only (PO) Strips

Traders might dissect MBS into IO and PO strips to capitalize on different interest rate scenarios and prepayment behaviors.

These strategies are based on the interest rate sensitivity and prepayment risk inherent in MBS, where IO strips benefit from lower prepayment rates (and hence, lower interest rates), while PO strips can benefit when prepayment rates decline due to higher interest rates.

Offers a nuanced approach based on interest and principal cash flows.

• IOs are typically bought when interest rates are expected to remain low or decline further, as this maximizes the interest portion of the MBS cash flows.
• POs are usually purchased when higher interest rates are anticipated, as rising rates lead to slower prepayments and greater principal cash flows.

In-Depth Prepayment Analysis

Advanced models consider borrower behavior under various scenarios, including economic downturns, job loss rates, and regional economic conditions.

This helps predict prepayment rates more accurately.

Important Considerations:

Liquidity

Some smaller issue MBS or specific coupons may be less liquid.

This can make them harder to buy or sell at desired prices, especially in a rapidly changing market.

Leverage

Many MBS strategies involve leverage (borrowing to increase investment size), which can magnify both gains and losses.

Complexity

Several strategies, especially those involving options or derivatives, can be quite complex and are most suitable for experienced traders.

Key Factors Affecting MBS Trading

Interest Rates

MBS prices are inversely related to interest rates.

When rates rise, MBS prices tend to fall, and vice versa.

This is because higher interest rates make new mortgages more attractive and reduce the demand for existing MBS.

Prepayment Risk

Homeowners can refinance or pay off their mortgages early.

This prepayment forces the MBS investor to reinvest the returned principal at potentially lower interest rates, which affects their yield.

Credit Risk

If homeowners default on their mortgages, the value of the underlying MBS declines.

This is why the credit quality of the mortgage pool is so important.

Risks of Trading MBS

Interest Rate Risk

Fluctuations in interest rates are the primary risk.

Prepayment Risk

The uncertainty of when a mortgage might be prepaid affects the MBS’s yield and value.

Credit Risk

Risk of borrower default, especially in non-agency MBS.

Liquidity Risk

Some individual MBS may not trade as frequently.

This makes them harder to buy or sell rapidly.

Pricing Dynamics and Valuation

Valuation

Valuation of MBS involves analyzing the present value of future cash flows from the underlying pool of mortgages while taking into account factors like prepayment risk, credit risk, and interest rate risk.

Advanced models incorporate assumptions about homeowner behavior, regional economic conditions, and embedded options within the MBS to estimate cash flows more accurately.

Ultimately, MBS valuation try to determine an appropriate yield spread over risk-free rates to compensate traders/investors for the unique risks associated with these securities.

Yield Curve Effects

MBS pricing is sensitive to changes in the shape of the yield curve.

A flattening curve can affect MBS differently than a steepening one, which can influence prepayment rates and yield.

Option-Adjusted Spread (OAS)

This is an important metric for valuing MBS, accounting for the option-like characteristics of homeowner prepayment behavior.

The OAS helps compare MBS with different prepayment risks to other fixed-income securities.

Prepayment Modeling

To better estimate prepayment risk, traders/investors often use prepayment models that analyze factors like:

• Current mortgage rates
• Housing turnover rates
• Seasonality patterns
• Loan age and size

This helps project prepayment speeds and cash flows more accurately.

TBA (To-Be-Announced) Trading

A significant portion of the agency MBS market trades on a forward or delayed delivery basis, known as the TBA market.

Investors trade based on general pool characteristics rather than specific mortgage pools.

Specified Pools

In contrast to the generic TBA market, specified pools are actual mortgage pools identified by specific criteria like loan origination year, geography, loan size etc.

These trade based on unique pool characteristics.

Relative Value Analysis

MBS traders use relative value analysis to identify pricing inefficiencies and potential mispricings between various MBS sectors/coupons compared to risk-free rates and spreads.

Convexity Risk

MBS have negative convexity, meaning their durations extend when rates rise and contract when rates fall.

This convexity risk needs to be hedged through instruments like interest rate swaps or Treasury futures.

Regulatory Aspects

The MBS market is regulated by bodies like the SEC, FINRA etc.

There are specific rules around disclosures, trading practices, capital requirements etc., that MBS traders need to comply with.

Sector-Specific Factors

Housing Market Dynamics

The health of the real estate market impacts MBS.

Factors such as home prices, housing market supply and demand, and geographic economic conditions affect mortgage default rates and prepayments.

Legislative and Policy Changes

Government policies, such as changes in mortgage interest deduction rules or housing finance reform, can influence MBS markets by affecting borrower behavior and lender practices.

For example, the loss of the mortgage interest deduction rule would likely decrease the value of mortgage-backed securities via:

• reducing the incentive for homeownership or demand for new mortgages
• potentially lead to higher mortgage default rates
• higher effective mortgage costs for borrowers
• increasing prepayment risk if borrowers seek more favorable financing options

Market Trends and Future Outlook

Impact of Non-Traditional Lenders

The rise of fintech and non-bank lenders in the mortgage market can alter MBS characteristics and risk profiles.

Environmental, Social, and Governance (ESG) Factors

Increasing focus on ESG criteria can influence MBS investment decisions, with a growing market for securities backed by environmentally sustainable or socially responsible mortgages.

Who Should Consider Trading MBS

Trading MBS is better suited for more sophisticated traders/investors who:

• Have a solid understanding of bonds and fixed-income investments.
• Are comfortable with the unique risks associated with MBS.
• Seek potential income and diversification in their portfolio.

Important Considerations

Before trading MBS:

• Clearly define your goals and risk tolerance.
• Thoroughly research any individual MBS or ETFs you’re considering.
• Understand the specific risk factors at play in the MBS market.

Why Trade MBS Over Treasury Bonds?

Trading MBS over Treasury bonds provides traders with higher potential yields as mortgage loans typically offer higher interest rates than government bonds.

MBS also offer diversification benefits by gaining exposure to the real estate market.

However, MBS come with additional risks like prepayment and credit risk that Treasury bonds don’t have.

The trade-off is between potentially higher returns and increased risk levels compared to the relative safety of Treasuries.

FAQs – Mortgage-Backed Securities

Why do MBS exist?

Mortgage-backed securities exist to provide liquidity to the mortgage market. 

Pooling various mortgages together and selling them as securities to investors allows banks and financial institutions to free up capital, thus enabling them to issue more loans. 

MBS also offer investors a way to invest in real estate without directly owning property.

This spreads the risk associated with individual mortgages across a broader base.

Why is the mortgage market subsidized in the US?

The mortgage market in the US is subsidized to promote homeownership, which is seen as a key driver of economic stability and growth. 

Government-sponsored entities like Fannie Mae and Freddie Mac provide guarantees on certain MBS, lowering the cost of borrowing for homeowners and making mortgages more accessible to a broader segment of the population. 

This support helps to stabilize the housing market and encourage economic expansion.

Critics argue that subsidizing the mortgage market through entities like Fannie Mae and Freddie Mac can create moral hazard, encouraging risky lending practices and inflating housing prices. 

They contend that these subsidies distort the market, leading to financial instability, as seen in the 2008 crisis. 

Also, critics believe that such government intervention unfairly benefits certain groups, while taxpayers bear the cost of potential bailouts when these entities face financial difficulties.

What are the different types of MBS?

There are two main types of MBS:

• pass-through securities
• collateralized mortgage obligations (CMOs)

Pass-through securities distribute the mortgage payments from the pool directly to investors. 

CMOs, on the other hand, are divided into tranches, each with different risk and return characteristics.

This allows market participants to choose a tranche that matches their risk tolerance.

What role did MBS play in the 2008 financial crisis?

MBS, particularly those backed by subprime mortgages, were central to the 2008 financial crisis. 

As the housing market declined and borrowers defaulted on their loans, the value of MBS plummeted.

This led to large losses for investors and financial institutions. 

The complexity and opacity of MBS and related derivatives exacerbated the crisis, contributing to the collapse or near-collapse of major financial institutions and a global economic downturn.

Can individual investors/traders buy MBS directly?

Yes, individual investors can buy MBS directly, but it is more common for them to invest in MBS through mutual funds or exchange-traded funds (ETFs). 

Direct investment in MBS requires substantial capital and an understanding of the complex risks involved, such as prepayment and credit risks. 

For most individual investors, participating through funds offers a more diversified and accessible way to get exposure to the mortgage market.

What is a TBA (To Be Announced) market in MBS?

The TBA (To Be Announced) market is a key feature of the MBS market, particularly for agency MBS. 

It allows investors to trade MBS before the specific pool of mortgages is determined. 

The TBA market provides liquidity and efficiency, as it standardizes the buying and selling process of MBS.

This enables large-scale trading without the need for detailed information about the underlying mortgage pools at the time of the transaction.

What is the difference between agency and non-agency MBS?

Agency MBS are issued by government-sponsored entities like Fannie Mae, Freddie Mac, or Ginnie Mae, and they come with a guarantee against default.

This makes them generally safer investments. 

Non-agency MBS, on the other hand, are issued by private financial institutions and don’t have government backing, making them riskier. 

The credit risk in non-agency MBS is higher, but they may offer higher returns to compensate for that risk.