Mortgage-backed securities (MBS) are investment products that pool together home loans and sell them as bonds to investors. These securities have long been a staple in fixed-income portfolios, offering relatively stable returns with lower risk compared to other asset classes. However, like most fixed-income investments, MBS are highly sensitive to changes in interest rates. As interest rates rise, the value and performance of mortgage-backed securities can fluctuate, impacting investor returns.

In this article, we’ll explore the relationship between rising interest rates and MBS, how these changes affect investor returns, and what strategies investors can use to navigate a rising rate environment.

Understanding Mortgage-Backed Securities

Before diving into the impact of interest rates on MBS, it’s essential to understand how these securities work. MBS are a type of bond created when a group of mortgages is bundled together and sold to investors. The cash flows from homeowners paying their mortgage payments are passed through to MBS investors in the form of interest and principal payments.

There are two main types of MBS:

• Agency MBS: These are issued or guaranteed by government-sponsored enterprises like Fannie Mae, Freddie Mac, or Ginnie Mae. They are considered safer because of the implied government backing, though they tend to offer lower yields.
• Non-agency MBS: These are issued by private institutions and do not have government guarantees. As a result, they carry more risk but may offer higher yields.

Because MBS are tied to home loans, their performance is directly influenced by factors that affect the housing market and mortgage interest rates. Rising interest rates, in particular, play a significant role in determining the value and returns of MBS.

How Rising Interest Rates Impact MBS Prices

Like all bonds, mortgage-backed securities are subject to interest rate risk, which refers to the inverse relationship between bond prices and interest rates. When interest rates rise, the value of MBS typically falls, and vice versa. This occurs because of the competitive nature of fixed-income securities: as new bonds are issued at higher interest rates, the older, lower-yielding bonds become less attractive, causing their prices to decline.

1. Decrease in MBS Value

When interest rates rise, the market value of MBS falls because the yield on newly issued securities becomes more attractive than that of existing MBS. This drop in value occurs for the same reason it does with traditional bonds: investors demand higher yields to compensate for the higher interest rates available elsewhere.

• Price and yield relationship: Since MBS pay a fixed interest rate based on the mortgages in the underlying pool, they become less valuable to investors when interest rates rise. As new mortgage-backed securities are issued with higher coupon rates, the price of older MBS with lower coupon rates declines to make their yields more competitive.
• Longer duration: Rising interest rates tend to extend the duration of MBS. Duration is a measure of a bond’s sensitivity to interest rate changes. As rates increase, prepayment rates typically fall, which increases the average life of the MBS. A longer duration means greater exposure to interest rate risk.

Investors holding MBS may see their investments decline in value as interest rates rise, especially if they are forced to sell the securities before maturity.

2. Slower Prepayments and Their Effects

One of the unique characteristics of mortgage-backed securities is that they are subject to prepayment risk. When homeowners refinance or pay off their mortgages early, the MBS investor receives their principal back sooner than expected. In a rising interest rate environment, prepayments tend to slow down, impacting the cash flows of MBS.

• Reduced refinancing activity: When interest rates rise, fewer homeowners refinance their mortgages because the cost of borrowing increases. As a result, the rate at which mortgages in the MBS pool are prepaid slows down. This leads to a longer duration of the MBS, which increases the security’s sensitivity to rising rates.
• Extension risk: The reduction in prepayments creates what’s known as extension risk. Because homeowners are less likely to pay off their mortgages early, MBS investors may hold onto the securities for longer than anticipated. This extended holding period locks in lower interest rates, reducing potential returns in a rising rate environment.

The slowing of prepayments in a rising interest rate environment can have a significant impact on the performance of MBS, particularly for investors looking for higher returns.

Impact on Yields and Returns

As interest rates rise, the yield on newly issued MBS also increases. While this is good news for investors purchasing new mortgage-backed securities, those holding older MBS with lower yields may face challenges. The impact of rising interest rates on MBS returns can be broken down into two key areas:

1. Lower Returns on Existing MBS

Investors holding MBS purchased before interest rates rose may see lower returns compared to new investors. This is because the coupon payments on older MBS are locked in at the time of purchase, and as interest rates rise, these fixed payments become less attractive compared to the higher yields available on new securities.

• Negative price impact: As mentioned earlier, rising rates lead to a decline in the market value of existing MBS. If investors need to sell their MBS before maturity, they may have to do so at a discount, resulting in lower returns.
• Less competitive yields: Even if investors hold onto their MBS until maturity, the yield they earn may be lower than what could be earned by investing in newly issued MBS or other fixed-income products with higher interest rates.

For existing MBS holders, rising rates may mean lower returns, especially if they cannot hold the securities to maturity.

2. Higher Yields on New MBS

For investors looking to buy MBS in a rising rate environment, the increase in interest rates can be a positive. New MBS are issued with higher yields to reflect the rising cost of borrowing, offering better returns to investors.

• Increased income potential: As new MBS are issued with higher coupon rates, investors who purchase these securities can benefit from higher interest payments. This makes MBS more attractive to yield-seeking investors.
• Inflation protection: Rising interest rates are often accompanied by rising inflation. Higher-yielding MBS can help protect against inflation by providing increased income to offset rising prices.

Investors entering the MBS market during periods of rising interest rates can take advantage of higher yields and potentially better returns than those holding older securities.

Strategies for Managing MBS Investments in a Rising Rate Environment

For investors with exposure to MBS, rising interest rates present both challenges and opportunities. Here are some strategies to consider when managing MBS investments during periods of increasing rates:

1. Laddering MBS Investments

One way to manage interest rate risk is through a laddered investment strategy. This involves purchasing MBS with staggered maturities, allowing investors to reinvest the proceeds from maturing securities into higher-yielding MBS as rates rise.

• Reduced interest rate risk: Laddering helps reduce the impact of rising interest rates because the investor can take advantage of higher rates as shorter-term MBS mature. By spreading out investments across different maturities, the portfolio becomes less sensitive to rate changes.
• Steady cash flow: A laddered approach ensures a more consistent flow of income, as different MBS mature and are reinvested at higher yields over time.

This strategy allows investors to maintain exposure to MBS while mitigating the effects of rising rates on the overall portfolio.

2. Focus on Shorter-Duration MBS

In a rising interest rate environment, shorter-duration MBS are less sensitive to interest rate changes and tend to perform better than longer-duration securities. By focusing on MBS with shorter durations, investors can reduce their exposure to interest rate risk.

• Lower volatility: Shorter-duration MBS are less affected by interest rate fluctuations, making them a more stable option during periods of rising rates.
• Quicker reinvestment opportunities: With shorter-duration securities, investors have the opportunity to reinvest their principal at higher interest rates more quickly, potentially improving returns.

By shifting towards shorter-duration MBS, investors can minimize the negative impact of rising rates on their portfolios.

3. Consider Diversifying into Other Fixed-Income Assets

While MBS can be a valuable part of a diversified portfolio, rising interest rates may warrant diversifying into other fixed-income assets that offer different risk-return profiles.

• Treasury Inflation-Protected Securities (TIPS): TIPS are government bonds designed to protect against inflation. As interest rates rise, particularly in an inflationary environment, TIPS adjust their principal value to reflect changes in inflation, making them a useful complement to MBS.
• Corporate bonds: High-quality corporate bonds may offer higher yields than MBS while providing more predictable income streams in a rising rate environment. Corporate bonds can be an attractive option for investors seeking to balance risk and return.

Diversifying into other fixed-income assets can help investors manage risk and take advantage of different opportunities during periods of rising rates.

Final Thoughts: Navigating the Impact of Rising Rates on MBS

Mortgage-backed securities are a popular investment choice for those seeking steady income and exposure to the housing market. However, like all fixed-income assets, MBS are sensitive to changes in interest rates. As rates rise, the value of existing MBS tends to decline, and slower prepayments can extend the duration of these securities, increasing interest rate risk.

For investors holding MBS, understanding how rising rates affect their portfolio is critical. By adopting strategies such as laddering, focusing on shorter-duration MBS, or diversifying into other fixed-income assets, investors can mitigate the negative effects of rising interest rates and position themselves for better returns in the future.

Ultimately, while rising rates can present challenges for MBS investors, they also create opportunities for those willing to adjust their strategies and take advantage of higher yields in a changing market environment.