Cheap mortgages are flooding the bond market, creating higher-paying investments

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Plunging mortgage rates have led to an explosion of home sales in 2020, and lenders have been absolutely inundated with applications as would-be homeowners try to take advantage of the record low rates. All those new mortgages don’t just sit on the bank’s books after they’re written, though – they’re flooding into the bond market and investors are scooping them up.

And that may create an opportunity for investors looking for higher-than-Treasury yields.

Low rates lead to surging demand

Rates continue their steep skid downward in 2020, with the average 30-year costing just 3.09 percent in the week of Sept. 17. With all-time cheap mortgage rates, would-be borrowers are racing to lock in low-cost money for decades.

While many borrowers are plunking down new money for houses, a huge portion of mortgages are refinancers looking to turn a cheap mortgage into a very cheap one. Nearly 69 percent of mortgages in the second quarter were refis, with the remainder as new purchases, according to data from Inside Mortgage Finance.

After those mortgages are established, many are often sold to government-sponsored agencies Fannie Mae, Freddie Mac and Ginnie Mae. These agencies repackage the loans into a bond called a mortgage-backed security. These bonds act mostly like normal bonds, but a key difference for investors is that they offer returns that are higher than traditional Treasurys.

And just like the supply of mortgages, the supply of these bonds is surging.

Fannie, Freddie and Ginnie notched record monthly volume in August, creating nearly $322 billion in new bonds based on single-family mortgages, according to Inside Mortgage Finance.

Bonds remain popular with some investors

Despite the rising supply of these bonds, some investors, including the Federal Reserve, are scooping them up and they remain in high demand. The Fed is among the largest buyers of mortgage bonds, as the central bank seeks to inject more liquidity into the financial markets.

These bonds are also popular among more sophisticated players such as institutional investors, because of their relative safety yet higher yield than Treasury bonds. And even banks, which may have sold off the underlying mortgages already, may be keen to invest in the bonds, because they’re awash with deposits and need to earn some money on that cash.

Currently the agency-backed mortgage bonds offer a yield that’s about 0.74 points higher than the 10-year Treasury note, though that figure fluctuates based on supply and demand for mortgage bonds and government notes.

That spread may prove attractive for many, but it’s not without some added risks.

Should individual investors check out mortgage bonds?

Mortgage-backed securities are typically the province of larger investors, but some retail brokers such as Charles Schwab allow individual investors to buy these specialty bonds, but you’ll have to call in. It’s also possible to buy the bonds as part of a mutual fund. One of the top mutual fund issuers, Vanguard, has created a mutual fund that invests in this kind of security, as has Fidelity.

But does this option look interesting for investors?

While investors are starved for yield these days, the answer is likely a resounding “meh.”

Compare these mortgage-backed bonds against typical bonds, and you’ll see some similarities as well as key differences that make them less attractive than they appear at first blush:

1. Mortgage bonds may be backed government guarantees

Treasury debts are issued directly by the federal government and backed by “the full faith and credit of the United States.” Only mortgage bonds issued by Ginnie Mae are explicitly backed with the same guarantee, though Fannie and Freddie offer guarantees and also have the ability to borrow from the Treasury, making their mortgage bonds safer. Private issuers may also create bonds that are backed by Ginnie Mae and also enjoy a government guarantee.

In a time of intense market volatility, the safest bonds are government-backed.

2. Payments may change over time

In a traditional bond, the payment is predetermined when the bond is sold, so the buyer knows the bond’s contractual payouts. With a mortgage bond, however, the payouts could change over time. That’s because as buyers refinance their mortgages, investors lose that portion of the payment. With rates so low, it makes sense for millions of borrowers to refinance, so the payouts on existing mortgage bonds may fall as refinancers make smart financial decisions.

3. Mortgage bonds pay monthly

Much like the mortgages underlying them, mortgage bonds typically pay out monthly. In contrast, government or corporate bonds usually pay out quarterly or semiannually.

4. Less transparency

In a traditional bond, the buyer knows the issuer, and so may be able to gauge creditworthiness better. For example, investors know the U.S. government or a large corporation such as Apple are high-quality issuers, so they may be able to more quickly size up the risk. With a mortgage bond, however, it may take more analysis to understand exactly what you’re investing in and who is on the hook for mortgage payments. They’re less transparent than traditional bonds.

With the current moratorium on foreclosures expiring at the end of 2020, a wave of mortgage defaults could usher in the new year, potentially hurting mortgage bonds. While experts expect foreclosures to rise, many see a much different foreclosure landscape from the last recession.

Bottom line

Investors don’t have a lot of great options when looking for yield these days, and while mortgage bonds do offer a higher yield, they’re going to be harder for individual investors to analyze. If the higher yield still tempts you, however, it could make sense to investigate mutual funds, which allow you to diversify your exposure across literally thousands of mortgage bonds.

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