25 Nov White Paper: Opportunities in Mortgage Derivatives
Voya Investment Management – White Paper: Opportunities in Mortgage Derivatives
With approximately $8.7 trillion outstanding, mortgage-backed securities (MBS) are among the largest sectors of the U.S. bond market. And given its lack of homogeneity, mortgages offer many alpha-generating opportunities
The bulk of the mortgage-backed bond market is comprised of agency MBS; that is, securitized pools of mortgages guaranteed by Ginnie Mae (a federal agency and thus backed by the full faith and credit of the U.S. government) or Fannie Mae/Freddie Mac (publicly owned but government-sponsored enterprises that are considered to possess implicit government backing). The simplest and most popular mortgage-backed securities are called “pass-throughs”, and they entitle investors to a pro-rata share of all principal and interest paid on a basket of similar mortgages.
Pools of agency-backed mortgages may also be formed and owned by special purpose vehicles, known as collateralized mortgage obligations (CMOs), which seek to mitigate the uncertainty inherent in MBS — primarily prepayment risk — by redirecting risk among various “tranches” of securities, each with different maturities, payment schedules and risk/return characteristics. Mortgage derivatives have become a classic arbitrage-based alpha-generating asset class, and the market’s ongoing need to distribute, price and digest prepayment risk makes them a viable investment vehicle over the long run.