5.518% With US Government Backing? What Are Mortgage-Backed Securities?

A US-government backed bond that pays 5% or even a bit more is what many in our community often ask about & that's what we'll be talking about in today's video:
1. What are mortgage-backed securities (or MBS)?
2. What are the risks of MBS?
3. What are some MBS paying right now? And where can I find them? 

Transcript

SPEAKER_00 0:00

Are you looking for a 5% plus yield on safe bonds with an explicit government guarantee? If yes, then let's talk about mortgage-backed securities or MBS. Hello everyone and welcome back to Markets with Markers. Many savers and investors in our community often tell us that what they're looking for, what would make them happy and sleep well at night, is a bond with US government backing that pays 5% or even a bit more. Now, at the time of this taping, as per April 6, 2026, rates are at attractive levels relative to where they have been over the past two decades. But you can't quite get to 5% with US Treasuries. The benchmark 10-year treasury pays only 4.34%, and even the highest yielding 20 and 30-year treasuries both show a yield of no more than 4.89% on the US Treasury's par-yield curve rates page. But if you're willing to look a bit deeper, mortgage-backed securities might be an option worth considering. The market considers mortgage-backed securities free of credit risk for all practical purposes if they are issued by an agency that enjoys an explicit or implicit guarantee by the US government. The government backing comes in addition to the security that comes from the mortgages itself that the MBS holds. And at the time of this taping, some agency MBS show assumed yields to maturity of up to 5.518% on Schwab's mortgage-backed securities page. As our Diamond Nasdaq regulars know, however, it's always more risk for more return in finance. And you may already be wondering what the catch is to get these 5% plus yields if it's not credit risk. So, with that in mind, here are the three topics that we'll be covering today. 1. What are mortgage-backed securities or MBS? 2. What are the risks of MBS? And 3. What are some MBS paying right now? And where can I find them? Let's get started. What are mortgage-backed securities or MBS? Many of us will be familiar with how mortgages work. So let's take a residential, 30-year fixed mortgage as an example, as these are the mortgages often used for MBS. In year zero, a home buyer borrows a large amount of money and pledges their home or future home as safety, as collateral, as the industry says. But over time, as the homeowner gradually pays down the original loan, more of the regular payments will go to repaying the principal, and less and less will be for current interest, until the mortgage is fully paid back. There's one twist here though, and it favors the home buyer. Whenever the home buyer, the borrower, wants, they can pay down as much principal as they want, or even repay the entire mortgage early without incurring any penalty. This principal prepayment option allows the homeowner to be debt-free earlier than plant, if they come into some extra money, for example. But it also allows the homeowner to refinance, meaning if rates fall, they can take out a new, cheaper mortgage and use the amount to pay off whatever is left of the older, more expensive mortgage. A mortgage-backed security or MBS takes a bunch of mortgages, like the 30-year mortgages we just talked about, maybe several thousand of them, packages them into one big bundle and sells it off in smaller amounts to investors. In other words, if you invest in an MBS, you're buying a small slice of the underlying mortgages from the original issuer. In return, you will get your slice of the payments that come in from the homeowners, both from the regular payments, but also from any early repayments. And because the MBS passes all these payments on to their investors every single month, an MBS is also called a pass-through security. So far, so good. One could say that you essentially become a mortgage lender if you buy an MBS. But why would the US government give you extra comfort by guaranteeing your investment either explicitly or implicitly? Because it wouldn't generally do that for any other private lending. And the answer is that the US government guarantee on residential MBS is essentially an indirect subsidy to make it easier to buy and refinance private homes. With the government guarantee, banks can quickly sell off any mortgages they just made and then use the proceeds from the sale to extend new mortgages to more home buyers. So the market for home loans is more liquid and it becomes easier and cheaper to get a 30-year fixed mortgage than it would otherwise be without this guarantee. In this video, we'll focus on the three agencies that issue the vast majority of government guaranteed MBS. The Federal National Mortgage Association or FANIME for short, the Federal Home Loan Mortgage Corporation, or Freddie Mac, and the Government National Mortgage Association or Ginime. Now, FANIME and Freddy Mac issue their own MBS and have an implicit guarantee by the US government only. Like for some agency bonds, an implicit guarantee by the US government means that this guarantee is not explicitly written into law. There is no contractual or statutory promise. Instead, there's a widespread market belief or perception that the US government will step in to support or bail out Fannie Mae and Freddie Mac if it's needed. And they actually did so during the 2008-2009 Great Financial Crisis. Chinime, on the other hand, has an explicit guarantee from our country. This means that it enjoys the full faith and credit of the US government and guarantees MBS issued by private lenders instead of issuing its own Ginime MBS. Despite these technical differences, the markets generally treat all MBS from either Fanime, Freddy Mac, or Ginime, or agency MBS as they are called, as free from credit risk for all practical purposes. We will use the terms agency MBS, government guaranteed MBS, and government-backed MBS interchangeably throughout this video. However, you should be aware that there are some non-agency MBS or private label MBS out there as well. These non-agency or private label MBS are not guaranteed by the US government in any shape or form. These are not the types of MBS that we will be talking about today. So, back to the government guaranteed MBS that we will be discussing further in this video. Even though Fanime, Freddie Mac, and Ginime are either implicitly or explicitly backed by the US government, you should know that they are still not completely risk-free. Which leads us to the next section of today's discussion. What are the risks of MBS? As we just discussed, agency MBS with their government guarantee are considered free of credit risk for practical purposes. You can basically assume that you will get all the payments that are due to you. So let's look now at three remaining key risks that explain the somewhat higher yield on agency MBS in comparison to US treasuries. The first risk, and probably the main one, is the prepayment risk that we already mentioned before. If interest rates go down, many homeowners will refinance their mortgage, meaning they will take out a new, cheaper mortgage and pay back their older, more expensive mortgage early. In this case, you as the investor will receive all interest payments that are due to you up to this point, and you'll get the entire remaining principal back as well. But you may then sit on a large amount of cash that you may not be able to reinvest at the same rates as before. In fact, it's very likely that you may have to settle for a lower rate because lower rates are usually what triggers an early refinancing. In this respect, MBS are similar to callable bonds. And like for callable bonds, the likelihood that borrowers will switch to a cheaper loan when rates fall also means that price gains on the secondary market will be lower for MBS than for fixed rate bonds. This is what the market calls negative convexity. So that was the first risk. Prepayment risk if interest rates go down. The second risk is extension risk, which happens when interest rates go up. If interest rates go up, you will essentially be stuck with the rates you have. Remember, the rates of the underlying mortgages are fixed for 30 years, and if rates go up, homeowners will have no incentive to refinance. On the contrary, they will probably make only the minimum required principal repayments and try to keep their low rates for as long as possible. The market calls this extension risk because the effective maturity of the underlying loan portfolio may turn out to be longer than initially expected. And for the same reason, your money is then locked up for longer than you may have expected, just as rates go up, you may see a potentially steeper fall for MBS prices in the secondary market than for bonds with a fixed maturity. Which is the other side of the negative convexity that we discussed earlier, if you want. The third risk is the potential unpredictability of your cash flows from an MBS, even though your yield is fixed. Remember, all payments from the underlying mortgage portfolio are directly passed through to you every month. So, for example, if more borrowers decide to repay early, you'll get more cash early on possibly, but then less cash in later payments and your cash flows may end earlier than you were expecting. From this perspective, an MBS may provide attractive extra income in your portfolio, but may not be able to fully replace the guaranteed fixed income you would get from non-callable bonds and annuities. And one comment about taxation. Most payments that an MBS passes through to you will be a combination of interest payments and principal repayments. The interest portion may be taxed at your full ordinary income tax rates at both the federal, state, and local levels. The principal repayments, on the other hand, will be tax free as they are considered a return of your initial investment. So, at the beginning, most of your monthly distributions may be fully taxable, but the proportion should shift and an increasingly larger part should come from tax-free returns of capital over time. Which leads us to the next section of today's video. What are some MBS paying right now? And where can I find them? The 5.518% MBS example from before comes from Schwab, who, in our experience, have the best online offering and even a dedicated MBS screener. Fidelity offers MBS as well, but they are harder to find on Fidelity's website. We haven't found a dedicated screener, so you would need to filter or search for issuers when looking online. And that's a bit more cumbersome when you have to look up FunnyMay, Freddy Mac, and Ginnie May separately. In many cases, and with all brokers, you may also want to give your broker a call when looking for MBS. It seems their bond desks often may have more on offer than what they put online. Wherever you buy though, keep in mind that neither yields, maturities nor cash flows are guaranteed with an MBS, even if you are a buy and hold investor. As we discussed earlier, borrowers may potentially increase or decrease their prepayments as interest rates and market conditions change. For example, the assumed yield to maturity of 5.518% here for this MBS from Chinime is just Schwab's best estimation, best guess, at the time of this taping on April 6, 2026. And even if you do get this 5.518% for a while, it will almost certainly not be locked in until the notional maturity of this agency MBS in November 2053. Any MBS is a self-liquidating fund as borrowers repay their principal over time, and additional prepayments may even accelerate the principal reduction. To repeat it once more. In fact, Schwab assumes that the remaining average life of a mortgage in the portfolio of this specific MBS is just a little bit more than two years, based on this assumed PSA, the prepayment speed assumption. But if you understand these risks and uncertainties and are comfortable with them, the right agency MBS may still be a potentially attractive investment. After all, an assumed yield of 5.518% without any credit risk for all practical purposes isn't too bad in the current environment. Even with a shorter assumed average life of 2.183 years. Comparable treasuries in the 3 to 5 year range may pay you below 4% at the time of this taping, as you can see here. Now, if you decide that agency MBS may fit your individual circumstances, goals and expectations, and you are considering adding some to your portfolio, you'll have to make one more decision. Should you buy directly or via a fund? Buying directly gives you more clarity and control and may save you a bit of cost. It has one potential hurdle though. As you can see here, the minimum face amount you have to buy is anywhere between 12,000 and 25,000 for the bonds that you can see on this screenshot. Now, MBS can be complicated. And in this case, for example, the 25,000 minimum quantity for the Chinime MBS from before doesn't necessarily mean$25,000. Let me explain what I mean. As borrowers make their monthly payments and maybe some extra principal repayments on top, the total principal amount in the mortgage pool keeps going down. And when you buy an MBS, you'll only have to purchase the remaining outstanding principal. This makes sense because why would you pay for a loan amount that has already been repaid, right? So this factor of 0.16 here, for example, tells you that only about 16% of the initial principal of this Chinime MBS are still outstanding, while the other 84% have already been repaid. So your purchase price is proportionally reduced as well from the initial$25,000. And the estimated total cost here shows you that you may only have to pay about$4,321 for what used to be an initial face amount of$25,000 for this Ginnie May bond. If you are interested in learning more about how to buy individual MBS and how these estimated total cost numbers are calculated, drop us a comment below or in our VIP member zone if you are a VIP Investment Club member, and we'll see if we can pull together some step-by-step tutorials. Now, this estimated total cost of$4,321 is still a decent sum for a minimum purchase. And for a newer agency MBS, the cost may be basically the full face amount of up to$25,000 anyway. What this means is that buying agency MBS via an ETF or mutual fund may be a good option if you want to build a diversified exposure with smaller amounts and better liquidity, andor want to delegate the management responsibility to professionals. In fact, agency MBS with their complexity and often high minimum amounts are one of the asset classes where we at Diamond Nestec generally recommend starting with funds, and only to consider buying individual MBS once you have built some experience and or have the required amounts to build a diversified portfolio yourself. Plus, some MBS funds can show even potentially higher yields than individual agency MBS. For example, the Janus Henderson Mortgage-Backed Securities ETF, ticker JMBS here, shows a trailing 12 months cash distribution yield of 5.58% on Morningstar at the time of this taping. And if agency MBS and their potentially attractive yields without credit risk for practical purposes are something that may sound interesting to you, join us in our brand new VIP Investment Club, where we'll be diving deeper into JMBS and some other similar funds that can give you potentially higher yielding liquid exposure to agency MBS and other mortgages. As we often say at Diamond Nestec, everyone's financial journey is different. What do you think about MBS? Is it for you, and what else are you investing in right now? Drop a comment below and let me, Chen, and everyone else know. Thanks for watching and see you again soon.