Mortgage bonds keep gaining fans: Community banks add weighting to loan surrogates

If your community bank’s bond portfolio looks like the rest of the industry’s, you own more mortgage-backed securities (MBS) than ever. There are a bunch of reasons for this, most of which you’re aware of, but some you may not be. The MBS that community banks tend to own are a small piece of the overall mortgage pie. Around 88% of all mortgage securities are backed by 30-year fixed rate loans, which have scant appeal to bank portfolio managers.
Thirty-year fixed rate pools long durations, back-loaded cash flows and price volatility profiles are outside of policy limits for most community banks. Nevertheless, there are enough mortgage bonds that do fit these risk/reward profiles to go around. We will discuss some of the more popular items, and where the current opportunities reside. Perhaps it’s time for a ride on the MBS Express.
Growing trend
The average community bank has around 60% of its bonds in some type of amortizing securities. These include the garden variety straight pass-thrus, adjustable rate MBS, collateralized mortgage obligations (CMOs) and Small Business Administration (SBA) pools. They are almost all issued by the federal government or its agencies, have good liquidity and low risk weights.
And, since they act like loans, bankers can get their minds around the cash flows. That’s not to say they can totally control them. One of the drawbacks of MBS is that the repayment of principal is almost entirely in the hands of the property owners. Nevertheless, it’s easy to understand why a community bank would own a lot of pools.
Market machinations
Over the past decade, there has been a supply shift in the mortgage bond market. The overall MBS market has barely grown since 2008, when total outstanding balances were about $9.5 trillion. Today, they are right at $10 trillion outstanding, which is only a 4% increase in more than 10 years.
Also different is the noticeable growth in the multifamily MBS sector. Fannie Mae and Freddie Mac have issued around $140 billion in multifamily bonds annually in recent years, more than twice that of a decade ago. While they are still a minority of all outstanding MBS, they represent most of the overall mortgage market’s growth. They also have different cash flow characteristics, as there are principal lockouts and prepayment penalties attached to many of these pools that can help stabilize the overall portfolio’s duration swings.
Value investing
Yet another reason to consider adding MBS is the Fed’s still-active management of its still-large balance sheet. Since 2017, it has shed more than $350 billion of MBS and will continue to do so, even as it attempts to get down to an equilibrium level. All its recent additions to its balance sheet for the purpose of stabilizing the overnight repo market were in Treasury securities and were expressly not quantitative easing (QE), according to Chairman Jay Powell. The Fed is not adding any MBS to its holdings and has no plans to do so.
In the second half of 2019, the combination of the Fed being a net seller of MBS and the cash flow volatility produced by three rate cuts caused yield spreads to widen, if not  dramatically, then at least noticeably. Recently, 15-year fixed rate pools, which are the product of choice for many community banks, were available at spreads of around 60 basis points (.60%) over Treasuries. That may not sound like much, but that is around 15 basis point better than the beginning of the year; further, spreads on many of the other products that community banks own actually narrowed on the year.
The skeptics of this sector (you know who you are) would possibly assume that the spread widening has caused the market value of their currently held MBS to crater. They, on balance, would be wrong. The Fed’s rate cuts produced enough of a tailwind to all investment sectors so that prices actually rose in 2019; it’s just that mortgage bonds’ prices didn’t rise as much as others. That would seem to indicate relative value.
In sum, there are several back stories to the mortgage security market going on that have created “opportunities.” One need not step out of his or her comfort zone within the MBS market to take advantage. Maybe 2020 will be a year of relative stability with interest rates, which could cause yield spreads to return to historical levels. All these are reasons for your community bank to be a fan of mortgage-backed securities.