For fixed income investments, investment-grade bonds form the bedrock of their allocations. The major bond market indexes—such as Bloomberg Aggregate—are filled with Treasuries and investment-grade corporate bonds. But the Agg and many other IG bond benchmarks contain another bond variety that is as good as gold.
We’re talking about agency Mortgage-Backed Securities (MBS).
Featuring higher yields, top-notch credit quality, and potential government backing, MBS bonds could be a strong contender for an overweight allocation. It’s no wonder why bond kings like Bill Gross and Jeffrey Gundlach have long favored mortgage-backed securities in their bond funds.
A Unique Asset Class
Ask many top bond investors what their favorite fixed income sub-asset class is and odds are they’ll name agency MBS. The reason for the love is their uniqueness among fixed income securities.
MBS are essentially pools of mortgages tied to homes or commercial properties. Banks and other lenders issue mortgages that are then packed and sold off to investors. The cash flows from the underlying mortgage properties form the basis of the coupons and repayments.
There are many firms that package mortgages together. But the agency piece is where it gets interesting for investors. The government trio of Freddie Mac, Fannie Mae, and Ginnie Mae are three of the largest buyers/packagers of mortgage loans. They were chartered to keep the U.S. housing market going during the high interest rate 1970s and 1980s.
The wonderful thing is that Freddie Mac and Fannie Mae are government-sponsored enterprises, while Ginnie Mae is government-backed. These agencies provide a layer of safety for the MBS, and in the case of Ginnie Mae, 100% backing. This provides them very high credit quality. In many cases, they are just under Treasury bonds.
But because there is some prepayment risk—as people can and do pay off their homes early—as well as some foreclosure risk, agency MBS bonds often yield more than comparable Treasuries. So, investors get more yield for not much in terms of risk. For big bond investors like DoubleLine’s Jeffery Gundlach or PIMCO’s Bill Gross, agency MBS provide the right combination of attributes that make them a top allocation. Both fund managers have built their largest bond funds on a bedrock allocation to MBS bonds.
Agency MBS Opportunity
The best part is that investors have an opportunity to build that bedrock allocation today at key valuations and high yields.
For starters, spreads between MBS bonds and Treasuries have only widened since 2022. Several key trends have been put in place. The Fed began its tightening regime, which pushed all bond prices and yields higher. But at the same time, the regional banking crisis also occurred. Property values and home prices have only drifted lower and pressures on repayment have grown. This has increased the perceived risk in MBS bonds versus other investment-grade fixed income assets.
This chart from Franklin Templeton shows the spreads versus the so-called MOVE Index, which looks at the volatility of Treasury yields. 1
Source: Franklin Templeton
Spreads are still at some of the most attractive points in a decade. You have to go back to COVID to get similar yields on MBS bonds.
Those spreads also make agency MBS bonds some of the cheapest securities of all bonds. Using research by Goldman Sachs, Franklin Templeton shows that since 2010, MBS bonds now stand at the widest and cheapest in percentile ranks versus all other bond types; this includes investment-grade corporates, junk bonds, and even international bonds.
Then there are some housing metrics to consider. According to Franklin, home prices peaked in March 2022, and the rate of price increases has slowed to 4.37% year-over-year by this past September. Additionally, building starts, sales, permit activities, etc., have also started to slow. Slow housing activities indicate lower organic supply of MBS, slower prepayment speed, and less paying down of the Fed’s MBS holdings. That’s positive for creating a supply/demand imbalance.
The demand side of the equation comes from institutional buyers who have stepped up purchases in recent weeks due to MBS strong yields.
Building Your Foundation
Given the size of the agency MBS market, many investors already have decent exposure to these securities in their bond portfolios. As we said, many bond indexes such as the Agg feature large holdings of Ginnie, Freddie, and Fannie bonds. Over 27% of the Agg is technically in MBS bonds.
But that doesn’t mean they aren’t worth overweighting in a fixed income portfolio, which is something Gundlach, Gross, and many other top bond managers have done.
To that end, adding some extra exposure to MBS bonds could make sense for additional yield and total returns.
MBS bonds are liquid enough that investors with sizable assets could buy individual bonds and any top brokerage firm could make that happen. But for many investors, buying ETFs or funds makes sense to overweight MBS bonds in a portfolio. Active managers may provide a bit more oomph. However, many active funds covering the sector don’t just stick to agency MBS and add commercial and non-agency debt into the mix to boost returns. That’s not bad, but investors looking for pure agency exposure might want to stick with the index funds in the area.
Mortgage-backed Securities (MBS) ETFs
These funds are selected based on their ability to tap into MBS at a low cost. They are sorted by their one-year total return, which ranges from 3% to 5.6%. Their expense ratio ranges from 0.04% to 0.64% and yields between 3.8% and 5.7%. Their AUM is between $320M and $36B.
| Ticker | Name | AUM | 1-Year Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| LMBS | First Trust Low Duration Opportunities ETF | $4.66B | 5.6% | 4.2% | 0.64% | ETF | Yes |
| VMBS | Vanguard Mortgage-Backed Securities ETF | $20.1B | 3.4% | 4% | 0.04% | ETF | No |
| JMBS | Janus Henderson Mortgage-Backed Securities ETF | $4.8B | 3.1% | 5.7% | 0.26% | ETF | Yes |
| MBB | iShares MBS ETF | $35.7B | 3% | 3.8% | 0.05% | ETF | No |
| SPMB | SPDR Portfolio Mortgage Backed Bond ETF | $5.7B | 3% | 5.7% | 0.05% | ETF | No |
| GNMA | iShares GNMA Bond ETF | $327M | 3% | 4.1% | 0.11% | ETF | No |
At the end of the day, agency MBS are a top security for fixed income portfolios and should form the bedrock of a bond allocation. They have higher yields and top-notch credit quality. And right now, they offer some of the best opportunities for investment. Yields haven’t been this good since COVID and they are cheaper than many other bonds out there.
Bottom Line
When it comes to investment-grade bonds, agency mortgage-backed securities are a top portfolio allocation for many investors. Offering higher yields and near-perfect credit quality, these bonds offer a unique opportunity to add income while not sacrificing on credit. It’s no wonder why many top bond managers have made them the bedrock of their portfolios.
1 Franklin Templeton (December 2024). Seizing the opportunity in US agency MBS
