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Host: Paul, we’re going to talk about impacts from the coronavirus pandemic, including the Federal Reserve’s purchasing of Treasuries and mortgage-backed securities, but let’s start with the basics and first go over what exactly is a mortgage-backed security?
Paul Varunok: It’s simply a security that’s backed by mortgage loans, guaranteed to that. Mortgages, for those in the US, are paid on a monthly basis, both principal and interest. And what happens in a mortgage-backed security is that principal and interest is passed through to the investor. That’s why you’ll often hear mortgage-backed securities as mortgage pass-through securities.
So in the US, mortgage finance is generally conducted by banks, credit unions and other financial institutions. And they extend credit to worthy borrowers seeking home ownership. After that mortgage is originated, that lender may seek to sell the mortgage into the secondary market.
To make the mortgage a little more attractive, the originator can sell the mortgage to a government-sponsored enterprise or GSE—such as Fannie Mae, Freddie Mac, and Ginnie Mae—and for a fee, the GSE will put a credit guarantee on that mortgage loan. Again, that makes it a lot more attractive to the end investor. The GSEs will then group a similar term loans and similar coupon loans into a security. And again, all those securities are paying monthly principal and interest that is passed through to the investor.
Host: How big is this market?
Currently, the agency mortgage-backed securities market is about US$6.4 trillion in size and is the second largest fixed income market next to US Treasuries. With that size comes great liquidity. You can transact very large volumes at very low costs. And during the global financial crisis, there were basically two markets that were operating in the thick of things and it was US Treasuries and US mortgages. Somewhat, little less liquid at that time, but still operated nonetheless and going into the coronavirus, same thing happened in March—little less liquid, not much, could still execute in very large size. And that’s very attractive to institutional investors and even retail investors where they know that they can get their money fairly easily.
Host: You mentioned government-sponsored enterprises, or GSE’s, like Fannie Mae and Freddie Mac, and Ginnie Mae—what’s the difference between them?
Paul Varunok: Ginnie Mae is the only mortgage-backed security that is a 100% government guaranteed. They are what we say in the Latin term, “pari-passu” with Treasuries, meaning they’re on equal footing with Treasuries. They have the exact same credit rating. So you say, “okay, so if they’re the same, why would I purchase a Ginnie Mae versus a Treasury or vice versa?” Ginnie Mae mortgage-backed securities, as all mortgage-backed securities, have an embedded option in them. And that option is the underlying borrower that we talked about earlier, taking out a mortgage loan—they’re able to freely prepay their loan at any time during the life of the mortgage.
So what does that mean? If you take out a mortgage, for example, you take out a US$200,000 mortgage to buy a house, and it’s a 5% interest rate that you’re paying. You’re going to pay about US$1,100 a month in principle and interest, that’s going to be your total payment. If interest rates fall, and now the prevailing rate is 3.5%, as a borrower, you can refinance out of that 5% into a 3.5% mortgage and your monthly payment will now be US$900, saving yourself about US$200 a month, US$2,400 a year. This is what we call pre-payment risks. So as interest rates decline, you have the risk of that your borrower is going to seek to refinance their loan and pre-pay their mortgage. What happens as an investor then—you receive your money back sooner than you were expecting, and you now need to reinvest at a lower prevailing interest rate, so your overall yield may be lower than what you initially expected.
Host: And that’s the environment we are in now, as a result of the pandemic, with rates at or near all-time lows.
Paul Varunok: So, currently if you look at mortgage rates at 3.31%, you look at the 10-year Treasury around 70 basis points, not quite at its low, but it’s very, very, very close. And the pandemic-influenced market will keep interest rates low for some time, and the Federal Reserve has said so much. So with interest rates so low, that means prepayment risk is quite elevated in mortgage-backed securities—all mortgage-backed securities—Ginnie Mae’s included. But like I was saying earlier, you’re compensated for that prepayment risk by earning an income above the risk-free rate.
So right now, on a nominal basis, Ginnie Mae current coupon yield is about 1.3%. And that represents about a 100-basis point pickup versus five-year Treasury. However, the Ginnie Mae security is only one to two years, so your actual pickup is a little bit better than that. On an option adjusted basis—that’s stripping out that prepayment option that the borrower has—you have about a 25-basis point spread to Treasuries, and that’s about the five-year average. So, on option-adjusted basis, you’re about a five-year average, on a nominal basis, you’re a little bit better, but we continue to believe that Ginnie Maes offers stability to a fixed income portfolio that’s looking for good income.
Host: What about the Fed’s moves—you mentioned them earlier, what is the impact you’re seeing?
Paul Varunok: The Federal Reserve has been buying US Treasuries and mortgage-backed securities as part of their quantitative easing [QE] operations. Ginnie Mae’s are obviously a part of this. Quantitative easing takes securities out of circulation because the Fed is buying them, putting them on their balance sheet, and that takes supply out of the market, so that tends to bring yield spreads lower. The Fed has been performing QE since March and they have purchased US$800 billion in securities. So they’ve bought a lot of securities in a very short time period. There will be a time where the Fed steps away from the market, and discontinues QE, most likely both in Treasuries and mortgages, but we feel that that time is relatively, further in the future.
We think that the compensation is fair from the five-year period and Ginnie Mae should perform well if interest rates sell off, moderately from here.
Host: Paul Varunok, Senior Vice President with Franklin Templeton Fixed Income—thank you for joining us.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. The price and yield of a mortgage-backed security will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. Bond prices generally move in the opposite direction of interest rates. An MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of an MBS or in an MBS’s credit rating may affect its value. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.