With the Federal Reserve tightening for the first time since 2006, investors may generate competitive returns from the comparatively stable market for mortgage-backed securities.

"Know your borrower!”—a lesson from the subprime mortgage meltdown last decade—is now the key to achieving outperformance through investing in the even-keeled market for government-backed mortgage bonds.

In normal times, agency mortgage-backed securities (MBS) generate more income than U.S. Treasuries because borrowers compensate investors for the risk that they will refinance their mortgage and force prepayment of the securities at a loss of the premium paid at purchase. But these are betterthan- normal times for MBS. These bonds are especially appealing today as the Federal Reserve embarks on a policy to nudge up benchmark interest rates from record lows. Policymakers, including Fed Chairwoman Janet Yellen, have said that the pace of tightening will probably be slower than usual. With interest rates flat or gradually rising, homeowners are less likely to refinance but still must compensate investors for the option to do so. That means we should see fewer MBS prepayments and a solid return for investors.

We seek to outperform by analyzing individual MBS at a granular level and identifying bonds with a comparatively low risk of prepayment. Such bottom-up analysis differs from the approach of most investors, who view MBS as homogenized securities with limited differences in risk. We seek to profit by buying MBS that we believe pose less risk than the market perceives and pocketing the extra yield offered for the higher estimated risk. When scrutinizing MBS, we look for the following signs of lower prepayment risk and higher potential return:

New mortgages. Homeowners who have recently closed on a mortgage rarely plan to refinance anytime soon. By purchasing MBS with a higher percentage of fresh mortgages, we push back our estimated date of a prepayment.

Small loans. When interest rates decline, homeowners who refinance small mortgages would likely reduce their monthly payments less in dollar terms than borrowers with larger loans. Ergo, they have less of an incentive to take advantage of lower rates with a refinancing. Also, fixed fees for refinancing pose a bigger disincentive to borrowers with smaller loans.

High loan-to-value ratios. Homeowners with minimal equity in their properties have difficulty refinancing mortgages because lower down payments in percentage terms usually prompt higher borrowing rates.

Lower credit scores. Homeowners with low credit scores often have difficultly accessing credit and will have to pay higher interest rates than borrowers with better credit scores. Refinancing may not be an option for them, and would become even harder to secure when interest rates rise.

By poring over thousands of MBS in search of the attributes listed above, we built a portfolio that outperformed the 1.51% return of the Barclays Mortgage-backed Securities Index last year. Much of the excess return stemmed from the slow rate of refinancing in the MBS pools we own. In 2015, our portfolio’s constant prepayment rate (CPR)—an annualized percentage of borrowers who terminate their loans—was 5.0% compared with 14.6% for the universe of bonds with comparable coupons. Mortgage borrowers pay MBS investors higher yields in order to have the option to pay off the debt before its stated maturity. Each incremental dollar not refinanced over a given period means fewer prepayments of principal at face value. (The vast majority of MBS trade above face value.)

At the core of our strategy is an awareness that MBS are not bloodless blocks of bonds but pools of mortgages, each with a living, breathing borrower behind it. Every borrower takes a distinct approach to homeownership and personal finance. By vetting each MBS from the bottom up, mindful of these nuances and looking for clues to borrower behavior, we seek to achieve attractive investor returns.


Other articles in this issue:

Through the Storm
Stock market volatility has spiked in response to immediate market concerns about energy prices, weakening economic growth in China and changes to monetary policy, as well as momentous capital-market shifts during the past 20 years. In times like these, investors earn their stripes by staying focused on their long-term goals.

By Paul Chew, CFA, Head of Investments

‘The Ultimate Mobile Device’: Redefining the Automobile
For more than a century, automakers have provided a way to find adventure and new possibilities just beyond the horizon. Now the industry is also trying to satisfy consumers’ Web-focused wanderlust.

By Simon Paterson, CFA, Equity Research Analyst

Present at the Creation: Early-Stage Venture Capital
While headlines often focus on Uber, Airbnb and other private companies valued at more than $1 billion, we are looking beyond the so-called unicorns to find opportunities for bigger returns in early-stage venture capital.

By Jacob Hodes, Co-Head of Private Equity and Keith Stone, Private Equity Venture Analyst


The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication.

The Barclays Mortgage-backed Securities Index is a market value-weighted index which covers the mortgage-backed securities component of the Barclays U.S. Aggregate Bond Index. The index is composed of agency mortgage-backed passthrough securities of the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac) with a minimum $150 million par amount outstanding and a weighted-average maturity of at least 1 year. The index includes reinvestment of income.

This communication and any accompanying documents are confidential and privileged. They are intended for the sole use of the addressee. Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.