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A Guide to Mortgage-Related Assets

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Jake Lowery

Jake Lowery, CFA

Senior Portfolio Manager, Mortgage Derivatives

Sunset over suburban town

Residential mortgages are transformed by investors’ de-risking process into a spectrum of assets, from very stable CMO bonds to mortgage derivatives, credit risk transfers and more. The result is a broad range of liquid investment opportunities featuring differentiated risk profiles and attractive risk-adjusted returns.

Executive summary

The agency mortgage-related assets market is massive: $9 trillion for agency mortgage-backed securities, and $1.25 trillion collectively for CMOs, mortgage derivatives, MSRs, and CRTs.1 It is also unusual within fixed income in that its primary risk driver isn’t credit risk, but prepayment risk—i.e., the risk that homeowners prepay their mortgages at a faster or slower rate than expected. Where mortgage-related assets stand out in a fixed income portfolio is their potential to increase yield, with products that can match a spectrum of risk levels and interest rate scenarios—including private credit. Beyond that, some markets such as mortgage derivatives are chronically inefficient, allowing the potential for hedge fund-like returns for investors diligent enough to engage in deep fundamental analysis.

The market

  • Agency mortgage-backed securities (MBS) are pools of private residential mortgages that are securitized into public bonds and guaranteed by government sponsored enterprises (GSEs), and are popular ways to potentially boost returns in more risk-averse fixed income portfolios. 
  • The further structuring of some MBS into collateralized mortgage obligation (CMO) bonds diverts prepayment risk into byproduct mortgage derivatives such as interest-only (IO) and inverse interest-only (IIO) securities, an estimated $70 billion asset class frequently used to juice yield in fixed income portfolios that can accept a medium risk level. 
  • Mortgage lenders sell off their mortgage servicing rights (MSRs), an estimated $75 billion private market where the securities tend to trade at a high average premium to agency MBS while having the same risk driver (prepayments). MSRs are an interesting diversifier and yield enhancer for private credit portfolios.2 
  • Credit risk transfers (CRTs) are high-yield bonds issued by the GSEs which act as “shock absorbers” for MBS credit losses. They perform well in high prepayment situations when other mortgage-related assets may not.3

Investment factors

  • With low correlations to both fixed income and equity investments, properly hedged mortgage-related assets offer potential diversification benefits in addition to their attractive rates of return. 
  • Agency MBS have a hefty 26% weighting in the Agg, meaning that strategies to outperform in the sector by allocations to mortgage derivatives and CRTs can be a critical part of beating the benchmark.4 
  • As mortgage prepayments are the largest risk in the asset class, good prepayment calls are the main driver of alpha. Yet most market participants spend little time on fundamental analysis, preferring to use out-of-the-box prepayment models. 
  • Prepayment rates that are 1% lower than market expectations can increase yield by 1% for the life of an IO/IIO asset.5 
  • With few large-scale or specialist investors in the market, it is possible to retain an information edge over other participants via deeper prepayment analysis and expertise to identify when standard prepayment models fall short.

Risks of investing 

The principal risks are generally those attributable to bond investing. Holdings are subject to market, issuer, credit, prepayment, extension, and other risks, and their values may fluctuate. Market risk is the risk that securities may decline in value due to factors affecting the securities markets or particular industries. Issuer risk is the risk that the value of a security may decline for reasons specific to the issuer, such as changes in its financial condition. The strategy invests in mortgage-related securities, which can be paid off early if the borrowers on the underlying mortgages pay off their mortgages sooner than scheduled. If interest rates are falling, the strategy will be forced to reinvest this money at lower yields. Conversely, if interest rates are rising, the expected principal payments will slow, thereby locking in the coupon rate at below market levels and extending the security’s life and duration while reducing its market value.

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1 As of 10/15/24. Source: BofA Global Research, Intex, FN, FH, GN, Bloomberg. 

2 MSR market size: Voya IM estimate, 10/31/2023. 

3 Federal Housing Finance Agency, Credit Risk Transfer Report, Fourth Quarter 2022. 

4 As of 10/15/24. Source: Bloomberg. 

5 Voya IM; Bloomberg.

This document has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. The material presented is compiled from sources thought to be reliable, but accuracy and completeness cannot be guaranteed. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. 

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