Are non-agency mortgage-backed securities a good bet?

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As interest rates continue to rise, mortgage-backed securities offered by some private companies may be a way to offset lower yields from traditional fixed-rate instruments. However, clients should be apprised of potential downgrades of the privately labeled pools.

Although a downgrade is likely, advisors and their clients have to remember what the downgrades represent: an “opinion and in some cases an overreaction,” says Terrance Martin, principal at Tranquility Financial Planning in McAllen, Texas.

While rating agency reports can certainly help demystify these investments, there are other data that should be explored.

“Remember, even the U.S. government was downgraded during the first government shutdown some years ago, and these same rating agencies rated agency mortgage-backed securities as As and AAAs before 2008. During the Congressional hearings, they said their ratings are just basically opinions and reminded investors to do their own research,” Martin says.

“So although we have to be wary of junk bonds, there may be an opportunity for some investors to capitalize on the missed pricing that downgrades may cause,” he says.

Mark Paccione, director of investment research at Captrust in Raleigh, North Carolina, says that non-agency mortgages have been one of his firm’s favorite fixed-income opportunities for the past several years.

Although it is not a new opportunity, many non-agency mortgages still trade below par, because many investors are not willing to buy below-investment-grade and often unrated bonds, he says.

“We believe housing should continue to benefit from a growing economy, thus benefiting the non-agency space,” Paccione says.

Kevin Meehan, regional president, Chicago, at Wealth Enhancement Group of Itasca, Illinois, says that his firm shies away from having clients directly own residential mortgage-backed securities, unless they are sophisticated institutional investors with the wherewithal to create a proper portfolio.

“Therefore, as part of our fixed-income portfolio, we access the space by utilizing specialist managers that live and breathe RMBS,” he says. “The majority of our RMBS exposure is seasoned holdings that contain a lot of data into the history and behavior of the underlying pool.”

Non-agency MBS is an area that Meehan and his team find interesting, both from a fundamental and top-down perspective. The traditional distressed crowd of institutional investors has largely left the space, after the “easy money” was made after the financial crisis.“Now you’re left with a space that some investors were burned by and won’t return to or one that people haven’t dedicated the time to understand,” Meehan says. “That’s interesting to us.”

This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.

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