If you’ve been avoiding adding private mortgage-backed securities to your investment portfolio, you may want to reconsider. Experts agree that these investments are safer than they were during the financial crisis and are worthy of a small portion of your portfolio.
Here’s why both ordinary and experienced investors are getting on board with mortgage-backed securities:
1. The potential for a high yield
According to U.S. News, some funds holding non-agency securities can yield up to 10%. The risks have only decreased since the last financial crisis.
There are fewer delinquent borrowers and consumers are doing well in terms of maintaining good credit. Home prices have appreciated by 6% over the last three years.
2. Agency securities will pay even if a homeowner defaults on their loan
Some agency-backed securities carry an explicit guarantee to pay the principal and interest income even when a homeowner defaults on their loan. For example, Ginnie Mae obligations are guaranteed by the Federal Housing Administration and they’ll use federal tax revenues to pay if needed. Other government-authorized securities work similarly, like Fannie Mae and Freddie Mac.
3. Non-agency securities are safer today
During the financial crisis, private-label mortgage securities were attractive to investors looking for high yields due to the higher interest rates charged to high-risk home buyers. That backfired in the wake of massive borrower defaults. However, today things are different.
Today’s private-label securities are safer because the standards borrowers must meet are stricter than ever. Another good sign is that many non-agency securities created ten plus years ago are still being traded today.
Commercial mortgage-backed securities are safer as well since CRE properties bring in long-term steady revenue from rent. CMBS loans are provided to investors for properties used for retail, office, multifamily, hotels, and warehouses. If you’ve got the capital, a CMBS is a great investment. To learn more, this guide will tell you everything you need to know about CMBS loans.
5. Mortgage-backed securities lower portfolio risk
MBS assets are highly liquid and provide the diversification necessary to lower portfolio risk. There are more than $7.3 trillion in outstanding assets and the average daily trading volume is $270 billion. It’s extremely easy to find buyers and sellers in this market. As discussed earlier, stricter lending standards have lowered the risk of default, making the market safer.
6. Low volatility; high Sharpe ratio
Historically, MBS have experienced relatively low volatility as compared with other fixed income asset classes. The Sharpe ratio has also been historically high.
7. Lower transaction costs
The transaction costs related to buying and selling mortgage-backed securities tends to be lower than other assets.
Know what circumstances will affect your investment
Before investing in a mortgage-backed security, be aware that your investment can be affected by interest rates and pre-payments. For instance, if a homeowner sells their home, they’ll need to pay off the rest of their mortgage. If that pre-payment slows down, your 10-year investment could turn into a 15-year investment.
If you’re a rookie investor, it’s probably best to hold off on mortgage-backed securities and opt for exchange-traded funds like Vanguard REIT. If you are an experienced investor and you don’t need your money right away, you could safely allocate up to 10% of your fixed-income portfolio to MBS.
Do your research
If you’re going to invest in a residential MBS, find one in a market where homes are rising in value rather than falling. Falling prices undercut homeowner equity, and unfortunately, homeowners who lose equity are more likely to default on their payments.
Mortgage-backed securities are worth the effort
Managing mortgage-backed securities requires more effort than other investments, but it’s worth the time and energy if you want to diversify your portfolio. There’s certainly more risk involved in private MBS investments as opposed to government-backed investments, but that doesn’t mean you should only choose the latter.
Both have benefits, and like every investment, there will always be risks.