• Pools that in the last 12 months have shown low monthly repayment rates on the remaining mortgages in the pool.
• Home owners with high FICO scores. These people could have refinanced but have chosen not to.
• Underlying mortgages with small balances. The costs of refinancing (appraisals, legal fees and the like) don’t make sense for small balances.
There are other factors including but not limited to, geographic location and spread; the type of mortgage; government guarantee rates; availability and cost of private mortgage insurance that should be employed to carefully screen out mortgage pools with high refinancing risks.
An example of such a bond is FN AD3828, which is guaranteed by Fannie Mae. The underlying mortgages yield 4.4%. It was issued in April 2010, and 83% of the issue has already paid off. The remaining 17% is less likely to pre-pay at a high rate. In fact, in the past 12 months, even as interest rates dropped to record lows, the annualized monthly prepayment rate has averaged only 15.5%.
At a prepayment rate of 15%, the issue has a yield to weighted average life of 1.72% and even at a prepayment rate of 20% the yield is 1.40%, taking into account the amortization of the premium. Its duration ranges from 3.04 years at a 15% prepayment speed to 2.68 years at a 20% prepayment speed. These yields are far higher than comparable duration Treasuries, high-grade corporates and munis.
Another major benefit is that these securities pay monthly interest and principal. The above issue averages 2% to 2.5% per month of the remaining balance depending on prepayment spread. Therefore, as interest rates rise this cash flow can be re-invested monthly in higher-yielding issues instead of waiting 2 to 5 years for a bond to mature and getting less than 0.10% per month in income to re-invest while you wait. Essentially, they enable investors to dollar cost average into the bond market as interest rates rise.
Carefully selected, seasoned U.S. government agency mortgage-backed issues combine high yield, short durations, low interest rate sensitivity, high monthly cash flows and very high credit quality in a package that would be hard to duplicate in a laddered portfolio of Treasuries or even lower-credit quality muni’s or corporate bonds. They are a very attractive alternative to intermediate and longer-term bonds, as well as money market funds.
Hugh Lamle is president at M.D. Sass Investor Services, a leading investment management firm since 1972. The firm's assets under management exceeds $7 billion in hedge funds, private-equity funds, mutual funds and separately managed accounts.