With a low volatility profile and steady yield, returns from mortgage-backed securities beat other medium and high-quality fixed income securities over time. The market has had a radical reform since it took a hit during the financial crisis; those who seek a truly diversified global fixed income strategy should investigate the revised offering. Tom Mansley and Garry Singleterry explain why investors may find that the opportunity is too good to miss.

What are MBS?

A mortgage-backed security (MBS) is an instrument that is backed by a pool of mortgages, whereby the investor is entitled to the cash flows associated with those underlying mortgages. They have a low corre-lation with both equities and traditional bonds. Today, the majority of securities in the market are ‘Agency’ MBS, backed or owned by the US government or its agencies (Freddie Mac and Fannie Mae).

Non-Agency MBS are bonds issued by private entities, such as banks. These securities do not have a government guarantee and therefore offer a higher yield with increased default risk.

How has the market evolved since 2007?

• Lending standards have dramatically improved and are strictly regulated.
• Borrowers must have a stronger credit history to receive loan approvals, with stringent eligibility requirements.
• No more 100% mortgage financing; borrowers must have a sizeable deposit.
• Credit rating agencies now incorporate a wider set of potential downside scenarios in their setting of MBS ratings.

From a fundamental perspective, US housing markets are much more robust than they were pre-crisis. CoreLogic reported that at 31 December 2016, one million mortgages, or 2.6% of all mortgaged homes, were seriously delinquent (payment 90+ days past due date). This compares to a peak in serious delin-quency of 3.7 million units in January 2010. They estimate that rising home prices have brought positive equity to an additional 62,000 houses in the fourth quarter of 2016, leaving only approximately 3.2 million houses, or 6.2% of all residential properties with a mortgage, with negative equity by the end of the 2016. CoreLogic also reported that the national foreclosure inventory was approximately 329,000 homes, or 0.8% of all mortgaged homes, in December 2016, a 30% decline from the prior year-end.

Why now?

Given the proven benefits of the asset class as a source of yield, capital preservation and diversification, we think ignoring it would mean missing out on some really interesting opportunities. The US election and inauguration of President Donald Trump brought some uncertainty to the outlook for the US mortgage market. With both houses of the legislature and the administration in Republican control, there is a higher probability of the federal government reducing its influence on the mortgage and housing markets.

If any legislative changes are enacted in 2017 by the newly elected government, they would likely be aimed at trying to create a resurgence of a larger and more efficient non-agency mortgage market – with more interesting investment opportunities.