The Hidden Force that Will Drive Yields Lower

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Many investors fail to understand the nuances and complexities of mortgage-backed securities (MBS). As a result, few can appreciate institutional MBS investors' role in the recent bond market rout. Instead of complaining about recent bond losses, our time is better spent exploring the machinations of MBS investors to assess where yields might be going.

This somewhat wonky article explores the unique qualities distinguishing MBS from other bond types. These characteristics help us appreciate how MBS investors contributed to the recent yield surge. Further, gives bond investors optimism that a good opportunity is approaching with a big group of bond sellers out of the way.

MBS 101

MBS are bonds secured by individual mortgages having similar characteristics. The graph below from SIFMA shows that MBS is the second largest fixed-income security behind U.S. Treasury securities.

The prepayment option attached to the underlying mortgages makes MBS distinctive from other bonds. A mortgagee can partially or fully pay off their remaining balance at any time and for any reason. Further, small amounts of principal are paid monthly by mortgagees. These traits make investing in MBS challenging but rewarding.

Adding to MBS complexity, the timing of mortgage prepayments is not solely a function of the level of interest rates. For many reasons, individuals do not refinance mortgages when interest rates suggest they should.