Mortgage backed securities: what are they?

This type of investment is completely new for us here at Nutmeg – it’s something we’ve previously been unable to include in customer portfolios as the market has not been accessible for UK customers. We’re excited to be able own this holding because it provides good diversification away from UK bonds, and it’s a big part of the global bond market.

Mortgage backed securities (MBS) provide investment exposure to the pooled interest and capital payments of homeowners on their mortgages.

Here’s a simple outline of how mortgage backed securities work:

• When a homeowner takes out a mortgage the lender owns the debt – therefore it has money tied up in the physical asset class, in this case property.
• In order to free up this capital and reduce its risk, the lender pools mortgages together and sells on the debt to other investors, who in turn earn interest on the loans.
• The lender continues to service the loans, but has freed up the capital tied up in this way. Mortgage customers continue to pay the lender, but other investors now own the debt.

There are two general types of MBS; those pooled and managed by government agencies and those pooled by non-agencies.

The former of these two is a central pillar of the US bond market, comprising 30% of all US debt and, even during the years of the credit crisis, broadly 2008 – 2011, MBS were actually a less volatile asset than UK corporate bonds, as shown in the graph below.

Source: Macrobond data, 1 Jan 2008 to 31 December 2011

There are also different grades of MBS depending on the credit-worthiness of the collective borrowers in the pool. The highest quality MBS investments are known as ‘AAA’ (triple A) rated. Mortgage backed securities have been an unpopular asset class since the sub-prime mortgage market became one of the leading causes of the most recent financial crisis in 2007 and 2008. In fact, MBS are a key part of globally diversified portfolios. While it wasn’t previously possible for Nutmeg to hold MBS portfolios, it is now available as a physical ETF, listed on the London stock exchange.

The iShares ETF we have chosen for customer portfolios is at the higher quality ‘AAA’ end of the United States MBS market – this isn’t the kind of investment you heard about during the financial crisis, or in the movie “The Big Short”. It is quality-controlled in terms of the standards of the underlying home-stock as well as the credit-score of individual mortgage holders allowed. We’ve also subjected this investment to our usual rigorous level of analysis – find out more about how we choose our ETFs.

We have included this investment in portfolios because we believe that the prospects for the US housing market are good. This is, of course, dependant upon the ability of home owners to repay – which we are positive about as employment and wages continue to grow in the US. This investment represents a high quality and diversified bundle of mortgages that spreads the risk of default.

We have included the MBS in customers’ portfolios in order to diversify fixed income exposure away from the UK. We believe this ETF provides the best exposure to an improving US housing market; and it provides this exposure in US dollars.

As always, our expert team will be closely watching the US mortgage backed security market as part of our wider investment strategy and managing the risk in our customers’ portfolios accordingly.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest.