Agency mortgage backed securities are bundles of mortgages which are packaged together as one instrument and sold like a bond.  The payments from all the individual mortgages are then distributed to the holder of the agency mortgage backed security.

How Agency Mortgage Backed Securities Work

There are millions of residential mortgages you may have one yourself. While in some cases banks directly lend the money of the depositors, a large portion of time they don’t. Instead, they sell the mortgages to a government agency (GNMA) or quasi governmental agency (Fannie Mae or Freddie Mac). Those agencies package thousands of similar loans together and then sell them to public in the form bonds which are known as agency mortgage backed securities.

The bonds themselves are supported by the mortgage payments. Unlike most other types of bonds. typically borrowers pay back both principal and interest through monthly payments. There is no lump-sum distributed at maturity. In the case of an agency MBS, the interest and principal payments are guaranteed by the agency issuing the bond. For all practical purposes, the default risk is negligible.

Theoretically, the default risk for Fannie Mae and Freddie Mac are slightly higher because they are technically not part of the US federal government. However, when the real-estate market came apart in 2008, the federal government supported them with hundreds of billions of dollars of aid.  As GNMA, Fannie Mae, and Freddie Mac are responsible for the functioning of the housing market (financing over 90% of mortgages since the crash) almost everyone considers them much too important for the federal government to ever let them default.

Some mortgages don’t qualify for an agency mortgage, however they are in the minority. Of the around $7 trillion in residential Mortgage Backed Securities, 80% of them are Agency backed.

Why do Agency Mortgage Backed Securities yield so much more than treasuries?

An agency and treasury bond with the same duration will pay very different yields. In February 2011, 5 year agency mortgage backed securities yielded around twice as much (around 4.0%) than a 5 year US Treasury (around 2.0%).  A year later, the 5 year agency mortgage backed securities were yielding almost triple that of the 5 year US Treasury. Why would these securities, which have almost equivalent credit risk, have such different yields?

Agency Mortgage Backed Securities Have A Very Unique Risk: Prepayment Risk

Mortgages can be and often are paid back early. There are many reasons why a mortgage may be paid off early. For example, a borrower may be able to refinance the mortgage at a lower interest rate or may sell their house. However, prepayments or the lack of prepayments can greatly impact the returns of an investor in mortgage backed securities.

Increase In Prepayments

Typically, this occurs when interest rates have fallen and homeowners are refinancing. There are two negative consequences for investors in Agency MBS:

1) Lower returns on re-investment. Investors must face a worse interest rate environment than when they made the original investment.

2) Losses on the value of the bonds. If an agency mortgage backed security was bought at a price which was a premium to its face value, the investor will lose the difference between the premium and face value when its prepaid. As many agency MBS are currently selling at an 8 to 10% premium to their face value, an unexpected increase in prepayments would result in a reduction of that premium.

Decrease In Prepayments

Typically, this occurs when homeowners have trouble selling their houses or interest rates rise. Effectively, a decrease in prepayment extends the duration of an agency mortgage backed security. What might have been an attractive yield for a bond with a 3 year duration can become an unattractive yield for a bond with a longer duration, particularly if interest rates are rising.

Is the market more worried about increases or decreases in prepayments?

With agency mortgage backed securities selling at a big premium to face value and the Federal Reserve set to keep interest rates very low until 2015, an increase in prepayments is a much greater concern then a decrease in prepayments.

You Probably Own Agency Mortgage Backed Securities But Don’t Know It

Most core bond funds have a high percentage of their assets invested in agency mortgage backed securities. For example, the PIMCO Total Return Fund in one point during 2012 had over 50% of its assets in agency MBS. This is on the high end but, most broad investment grade Bond index funds, such the Vanguard Total Bond Market, will have about 31% of their assets invested in them.  Also, there are funds that invest only in agency mortgage backed securities.

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