By Neal Frankle 
Mortgage-Backed Securities (MBS) are financial instruments that are created by bundling together a group of mortgage loans and selling them to investors. MBS provide regular income through the interest payments made by homeowners on the underlying mortgages. These securities are appealing to investors who seek steady returns, but their performance is closely tied to interest rate movements. When interest rates rise, the value of MBS can fluctuate significantly, impacting the returns investors can expect.
Why Interest Rates Matter to MBS Investors
Interest rates, particularly those set by the Federal Reserve, directly influence mortgage rates and the broader bond market. MBS are a type of fixed-income investment, and like other bonds, their value is inversely related to interest rates. When rates rise, the value of existing MBS typically falls because new securities are issued with higher yields, making older, lower-yielding MBS less attractive to investors. This relationship between interest rates and MBS can affect both the income investors receive and the overall value of their holdings.
The Inverse Relationship Between Interest Rates and MBS Prices
One of the key dynamics in the MBS market is the inverse relationship between interest rates and bond prices. When interest rates rise, the prices of existing MBS fall. This happens because new MBS are issued at higher rates, offering more attractive yields to investors. As a result, the market value of older MBS, which pay lower interest rates, declines to adjust to the new rate environment.
How Rising Rates Impact MBS Prices
- Lower market value: As interest rates increase, the price of existing MBS declines because they offer lower yields compared to newly issued securities. Investors may sell off older MBS in favor of higher-yielding options, driving down prices.
- Reduced demand: In a rising-rate environment, investors often shift their focus to newly issued MBS or other higher-yielding fixed-income investments, reducing the demand for older MBS.
This inverse relationship makes MBS more sensitive to interest rate fluctuations, particularly when rates rise rapidly.
Prepayment Risk and Rising Interest Rates
One unique factor that influences MBS performance is prepayment risk. Prepayment risk refers to the possibility that homeowners will pay off their mortgages early, either by refinancing or selling their homes, which can impact the cash flow of MBS. When interest rates rise, the likelihood of prepayment decreases because homeowners are less likely to refinance their mortgages at higher rates.
Impact of Reduced Prepayments on MBS
- Slower prepayments: Rising interest rates mean fewer homeowners will refinance, leading to a slower prepayment rate. This can result in longer-than-expected cash flows for MBS investors.
- Extension risk: With fewer prepayments, MBS investors face extension risk, where the average life of the MBS is extended. This can lock investors into lower yields for a longer period, especially when new bonds offer higher rates.
While reduced prepayments may seem like a positive factor for MBS investors, the downside is that it increases the duration of the investment, exposing investors to further interest rate risk.
Yield Spreads and MBS Performance During Rate Hikes
Yield spreads are another important factor to consider when assessing the impact of rising interest rates on MBS. The yield spread is the difference between the yield on MBS and a risk-free benchmark, typically U.S. Treasury bonds. When interest rates rise, yield spreads tend to widen as investors demand higher compensation for holding riskier assets like MBS compared to safer government bonds.
How Rising Rates Influence Yield Spreads
- Wider spreads: Rising rates generally lead to wider spreads between MBS and Treasury yields, as investors seek higher returns to offset the increased risk of holding MBS in a volatile rate environment.
- Higher yields on new MBS: As new MBS are issued with higher yields, they become more attractive to investors, but this can put downward pressure on the prices of existing MBS with lower yields.
Wider yield spreads can benefit new investors entering the MBS market, but they can negatively impact the market value of existing MBS held by investors.
Credit Risk and Its Interaction with Rising Interest Rates
While MBS are often seen as relatively safe investments, particularly those backed by government-sponsored enterprises like Fannie Mae or Freddie Mac, they still carry some degree of credit risk. Rising interest rates can exacerbate credit risk, especially in a weakening economic environment, as higher rates can lead to increased defaults on the underlying mortgages.
The Effect of Rising Rates on Credit Risk
- Increased defaults: As interest rates rise, homeowners with adjustable-rate mortgages (ARMs) may face higher monthly payments, increasing the likelihood of default. Higher defaults can reduce the cash flow to MBS investors.
- Impact on non-agency MBS: MBS that are not backed by government agencies, known as non-agency MBS, carry a higher degree of credit risk. Rising rates can exacerbate this risk, particularly in periods of economic stress.
While agency-backed MBS are generally less affected by credit risk, non-agency MBS can see significant value erosion during times of rising interest rates, especially if defaults on the underlying mortgages increase.
Strategies for MBS Investors in a Rising-Rate Environment
Investors holding or considering MBS need to adopt strategies that account for the effects of rising interest rates. One approach is to focus on shorter-duration MBS, which are less sensitive to rate increases and help mitigate the impact of falling prices. Another option is to invest in adjustable-rate MBS, which can adjust their yields in response to rising rates, helping protect against price declines.
Key Strategies for Navigating Rising Rates
- Shorter-duration MBS: By investing in shorter-duration MBS, investors can reduce their exposure to interest rate risk, as these securities are less sensitive to rate changes.
- Adjustable-rate MBS (ARMBS): These MBS adjust their interest rates based on prevailing market conditions, providing some protection in a rising-rate environment.
- Diversification: Combining MBS with other fixed-income investments, such as Treasury bonds or corporate bonds, can help spread risk and balance exposure to rising rates.
Adopting a proactive strategy helps MBS investors navigate the complexities of rising rates while minimizing potential losses.
Opportunities for MBS Investors During Rate Hikes
While rising rates pose challenges for MBS investors, they can also create opportunities. As rates rise and prepayment rates slow, the steady cash flow from MBS becomes more predictable, which can be attractive for income-focused investors. Additionally, newly issued MBS with higher yields may provide better returns for those looking to enter the market.
Advantages of Higher Yields on New MBS
- Attractive entry points: Rising rates often create more attractive entry points for new investors, as newly issued MBS offer higher yields compared to existing securities.
- Predictable cash flow: With slower prepayment rates, MBS can provide a steady stream of income over a longer period, which is appealing in a rising-rate environment.
For investors willing to navigate the challenges of rising interest rates, MBS can still offer opportunities for steady returns, especially when incorporating strategies like investing in higher-yielding new issues or focusing on shorter-duration securities.
Conclusion: Preparing for the Impact of Rising Rates on MBS
Rising interest rates have a significant impact on mortgage-backed securities, influencing both their prices and yields. Understanding how factors like prepayment risk, yield spreads, and credit risk interact with rate hikes is essential for MBS investors. While rising rates can reduce the market value of existing MBS, they also present opportunities through higher yields on newly issued securities. By adopting strategies such as focusing on shorter-duration MBS or diversifying across different asset classes, investors can navigate the complexities of a rising-rate environment while still benefiting from the steady income that MBS provide.
For investors looking to manage the effects of rising rates on their portfolios, staying informed and proactive is key to achieving long-term success in the MBS market.