In today’s environment of low interest rates, there are few places to turn to add yield to your portfolio. Sure, you can tie up your money in 30-year Treasury bonds to lock in a 3.70% yield, but you will take it in the neck when interest rates rise. A 1% increase in interest rates will result in a devastating 20% price decline in 30-year coupon bonds. Not exactly the type of risk most fixed-income investors are looking to take. A better strategy for adding yield to your portfolio is to take prepayment risk on mortgage-backed securities (MBS). I am not talking about the toxic private label mortgage-backed securities that wreaked havoc on bank balance sheets during the financial crisis. There is certainly yield in private mortgage-backed securities, but there is also extraordinary credit risk. With housing in or on the verge of a double-dip recession, I don’t want to take credit risk in mortgage securities. The mortgage-backed securities I favor are those that carry no credit risk. Here I am talking about agency mortgage-backed securities. Agency MBS are backed by the full faith and credit pledge of the U.S. government. With agency MBS, you can isolate prepayment risk.
So what exactly is prepayment risk? It is the risk that during a period of falling interest rates, homeowners will refinance their mortgage before maturity. If you are an MBS investor, you do not want to see homeowners refinance. When a homeowner refinances, he is replacing a high-interest-rate loan with a lower-interest-rate loan. The result for the MBS investor is lost price appreciation and the forced reinvestment of principal at lower interest rates. Not ideal, but certainly nothing to lose sleep over. Instead of earning the stated interest rate on your entire principal, you will earn a lower rate on the prepaid portion of your principal. And in return for taking prepayment risk, you are compensated with a high upfront yield relative to securities without prepayment risk. In today’s environment, a portfolio of agency MBS securities may yield as much as 3.50%—that’s a 3% yield pickup on treasury securities with similar duration risk. Agency MBS securities carry no credit risk, limited maturity risk, and, in an adverse case scenario, you will earn a lower interest rate on a portion of your money. That is a risk worth taking.