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What Makes MBS the #1 Bank Investment Opportunity in Today's Market?

What Makes MBS the #1 Bank Investment Opportunity in Today's Market?

Release Date: May 19, 2021
Participants: Josh Kiefer, Scott Carrithers
Topic: Why Mortgage-Backed Securities Are a Good Investment Opportunity for Banks

Click here to listen now, or read the transcript below:

 

Scott Carrithers:

Welcome to the latest installment of The Leaderboard Report. I’m Scott Carrithers, managing director for Country Club Bank’s Capital Markets Group.

In today’s Leaderboard Report, Josh Kiefer, vice president of institutional fixed income sales, will talk about mortgage-backed securities, and why they are a great investment opportunity in today’s market.

 

Joshua Kiefer:

Thank you, Scott.

Most banks, including Country Club Bank, are flush with liquidity—and loans are unable to keep pace. As a result, we are being forced to grow our bond portfolios to try to capture some amount of spread over cash.

Today’s economic environment has not only shifted our asset mix more in favor of bonds, it has done so at historically low-interest rates. Therefore, the investment decisions we make today will have a major effect on future earnings and cash flows.

This is precisely the reason Mortgage-Backed Securities, or—MBS—are the #1 Bank Investment Opportunity in today’s market. To be clear, there are a number of different options in this sector—and not all of them are suited for your portfolio.

When shopping in today’s bond marketplace, the more “plain vanilla” the structure, the more identifiable the cash flows are. What you should avoid is a topic for another Leaderboard Report. Today, we are going to talk about the few structures you should consider, and we’ll explain why. 

The first is a 10-year 1.5% coupon fully amortizing pool issued by Fannie Mae or Freddie Mac. This structure will capture roughly 75 basis points in yield to a 4-year average life, and it will maintain a steady principal and interest cash flow stream—no matter what rates decide to do in the future. This payment behavior is due mostly to the types of borrowers who are issued 10-year mortgages. They tend to have little incentive to refinance—which is the main reason for unexpected prepayments.

The second MBS structure to consider is a 15-year 1.5% coupon pool issued by Fannie Mae or Freddie Mac. This structure will capture roughly 1.2% in yield to a 5.25-year average life. This structure could experience slightly more volatility in cash flow when compared to the 10-year fully amortizing pass-through pool; however, it will also maintain a steady principal and interest cash flow stream in most rate-shock scenarios.

The third MBS structure is for portfolios willing to accept a little more volatility in the timing of their cash flow. This structure is a 20-year 1.5% coupon pool issued by Fannie Mae or Freddie Mac. This structure will capture roughly 1.53% in yield to a 6.2-year average life—and provide monthly principal and interest cash flows. Although this structure has the least predictable cash flows of the three, we believe it is a great way to diversify into a discounted dollar price, which effectively eliminates the risk that early prepayments have on your yield.

Ideally, we would encourage you to diversify into all three structures; however, if you are unwilling to go out too far, we recommend focusing primarily on the 10-year 1.5% coupon pool—and thank yourself for the consistent cash flows in the future.

The one thing all three of these structures have in common is their ability to self-liquidate. The reality is this: Rates are going to move higher, and loan demand will return. When this happens, would you prefer to borrow money at higher rates, or sell securities at a loss in order to fund loans? The ideal situation would be to sit back and collect principal and interest cash flows from your mortgage-backed securities portfolio and reinvest the proceeds into higher-rate loans.

Almost as important as the cash flow is the fact that your principal balance is going to shrink from month to month, meaning a lower multiple to calculate any unrealized loss in the future—when rates are higher and prices are lower. These characteristics are something you only get with mortgage-backed securities—making them the #1 bank investment opportunity in today’s market.

Although we’ve only scratched the surface on mortgage-backed securities, we encourage you to reach out to your CCB representative to have a more detailed discussion about the mortgage-backed security sector. Even with plain vanilla structures, it’s important to understand the collateral and mechanics of the security. 

Thank you very much for making time to listen in today.