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Mortgage-Backed Securities: How and Why Do They Fit in Credit Union Portfolios?

Credit unions are faced with a range of investment opportunities to deploy their excess liquidity.  As investment portfolios get larger, one asset class that is more frequently used is agency mortgage-backed securities (MBS).  In fact 82% of federal credit union investment portfolios greater than $50mm own agency MBS (calculated from NCUA 3Q2024 Call Reports). This raises the question – why do larger credit union portfolios increasingly rely on this asset class and what is the appropriate way to analyze them?  While the second part of that question can (and should!) take an entire book to explain, we’ll attempt to provide an overview of the asset class and the ways in which it can add value.

 

CD Ladders Vs. Amortizing Assets

For smaller credit union portfolios, the most straightforward way to build a portfolio which provides consistent liquidity is through laddering out a portfolio of CDs to target maturity dates.  However, this endeavor becomes more challenging as portfolios become larger and the relative value of CDs declines.  While there are other fixed-rate, fixed term investment alternatives, many CUs opt for MBS because the amortizing nature of the underlying loans provides liquidity via the monthly principal payments.  The addition of amortizing assets (whether fixed or variable rate) can effectively replace a short-term CD ladder with much less effort as specific maturity dates do not need to be targeted.  Rather, a choice between short and longer-average life assets will dictate how much liquidity will be generated by the investments.

 

Assumption of Call Risk Adds Yield

Many credit unions who are beginning to build more complex investment portfolios will consider purchasing agency callable debentures (bullets).  This introduction of call risk, or the risk that the investment will be redeemed early, offers additional yield to the bondholder.  Mortgage-backed securities have a similar risk as borrowers can choose to refinance their existing mortgages, resulting in early prepayments for bondholders.  However, the way in which call risk is reflected in MBS is different than in callable agencies.  When an agency callable is redeemed early, the entire security is redeemed early.  In MBS, a reduction in interest rates will gradually increase borrowers’ propensity to refinance, but the actual timing of the impact is slower, pulling down the outstanding balance rather than immediately returning all of the investor’s principal.  This creates less average life variability in MBS versus callables, making the projection of cashflows easier.

Once credit unions are comfortable assuming some call risk in order to lift portfolio yields, a frequent question is: how much more yield should I be earning for taking on that risk? While MBS spreads vary meaningfully over time, it is helpful to take a look at historical levels in order to gauge a ballpark spread to ensure the credit union is earning enough extra yield over CDs/bullets for the assumption of the embedded call risk.  As the charts below indicates, the average pickup in yield over the past ten years between a pool of 15-year MBS and a 5-Year Treasury has been just over 60 bps.

Several trends can be ascertained looking at this data, including the fact that spreads normally compress in a rising rate scenario.  One additional factor that is not apparent looking at these charts is that the volatility of interest rates also has a material impact on yields, so in environments where the rate outlook is uncertain, spreads will widen.

We are coming off a period where both overall rates as well as spreads were very attractive.  But as inflation declined and the Fed subsequently embarked on its rate cutting campaign, volatility diminished and MBS spreads began to fall as well.  MBS spreads are currently right on top of historical averages, with 15-year pools offering yields of approximately 4.72% versus the 5-Year Treasury return of 4.11%.  This pickup is reasonable given historical guidance, and compared to the lackluster rate levels available in CD markets, the rationale for using MBS to structure an investment portfolio which delivers both yield and liquidity remains as robust as ever.

Going forward, we’ll discuss strategies for selecting the best MBS pools for your portfolio and then extend that analysis to structured agency MBS.  As always, please confer with your Accolade advisory to determine the appropriate strategy for your credit union and let us know what topics you’d like to see addressed.


 

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