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Mortgage-Backed Securities

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​Mortgage-Backed Securities Strategy

Article Main Body
Why Invest in Mortgage-Backed Securities (MBS)?
Mortgage-backed securities are one of the largest sectors of the global fixed income market, offering investors a variety of potential benefits, including:
  • A broad and diverse opportunity set
  • MBS are backed by U.S. homes and the majority are collateralized by conforming loans and issued by the mortgage Agencies.  The mortgage Agencies, Fannie Mae, Freddie Mac, and Ginnie Mae, are mandated by Congress to assist in the provision of financing in the U.S. housing and mortgage markets.
  •  Attractive yield premium to Treasuries and swaps with over 30 years of price history

In addition to these primary benefits, MBS offer other potential benefits as well. MBS are among the most liquid fixed income securities in the world, and are attractive risk-based capital assets under Basel 1 and 2.1

MBS also have been among the world’s most attractive opportunities for alpha in broader fixed income portfolios due to the fact that trading is usually dominated by accounting and regulatory-constrained investors. These constraints can create attractive opportunities for total return investors. Because of the many potential benefits MBS may offer, financial institutions continue to make substantial allocations to MBS.

PIMCO’s Mortgage Experience
PIMCO is one of the largest and most experienced managers of mortgage-backed securities in the world. As one of the earliest investors in the sector, PIMCO has been employing MBS as in client portfolios since 1975.


In a market as deep and liquid as MBS, finding value requires a thorough understanding of the sector’s unique risk factors and opportunities. PIMCO analyzes MBS using proprietary models developed by our financial engineers and refined by our portfolio managers over many years. We believe the experience of our mortgage team and the level of sophistication of our proprietary analytic platform are critical factors in the successful management of MBS portfolios.

Investment Philosophy
Agency MBS have been tremendously liquid, frequently mispriced, and have exhibited robust mean reversion to fair value.

PIMCO’s goal in managing mortgage-backed securities is to generate consistent, long-term outperformance. In our efforts to achieve that goal, we employ a unique approach to the MBS market that emphasizes actively managed exposure to Agency pass-throughs, which we believe offer the greatest potential for risk-adjusted excess returns in a mortgage portfolio.

While we focus primarily on Agency pass-throughs, we also look for value and attractive risk-adjusted return opportunities in all segments of the larger MBS market. However, we believe the Agency pass-through market can offer the greatest potential for alpha due to its liquidity and credit quality. For Non-Agency MBS, Commercial MBS, and mortgage derivatives, we frequently demand more yield in compensation for the probability of principal loss and liquidity risk than the market typically provides.  As a result, PIMCO’s dedicated mortgage portfolios will be primarily concentrated in Agency MBS holdings.

We believe Agency MBS can offer the best opportunity for excess return in a mortgage portfolio. Our goal in managing MBS portfolios is consistent, repeatable, high-quality alpha.

Investment Process
Security selection is the core of PIMCO’s mortgage investment process. Using our proprietary analytics, we seek securities that offer the highest total return potential for the lowest amount of risk. The MBS markets can become temporarily and sometimes substantially mispriced, but Agency MBS demonstrate robust mean reversion to our proprietary modeled fair value. As a result, we have a value-oriented investment style and tend to be contrarians.

PIMCO does not rely on any single model in its investment process. Rather, we take a multi-faceted approach to MBS valuation, with three major components:

  •  Option-Adjusted Spread (OAS)
    Option-adjusted spread is the market standard for analyzing mortgages, but we believe it is weak in isolation and is a poor absolute valuation tool. We use OAS modeling as an important relative valuation tool when comparing securities, but never without supplemental analysis.

  • Empirical Modeling
    Empirical modeling serves as a critical tool designed to systematically exploit market opportunities. PIMCO’s use of empirical modeling derives from the belief that market prices reflect a substantial amount of prepayment information. The extent of prepayment information embedded in market prices combined with the liquidity of MBS make empirical analysis an extremely valuable tool.

  • Technical Analysis
    Analysis of technical factors impacting the MBS market provides critical insights. There are significant clientele effects in MBS trading - as the major MBS investors, such as banks, mortgage servicers and insurance companies are often driven by accounting motives rather than value. As a total return value investor PIMCO seeks to profit from this type of trading. Further, overseas investors continue to be a major source of MBS demand and our close contact with major foreign institutions gives us unique insight into the behavior and preferences of large international buyers and sellers.

We believe using this multi-faceted approach is the most effective and robust method for evaluating the return potential of MBS and the risks they entail.

PIMCO’s Mortgage Credit Research and Portfolio Management
As mortgage credit research has become increasingly important to understanding the workings of the housing market and managing portfolio risks, PIMCO has expended tremendous time and resources to enhance our mortgage credit capabilities to meet the demands of a rapidly evolving mortgage landscape.  In addition to expanding the team dedicated to security analysis, we have added team members who are dedicated to analyzing and forecasting delinquencies and losses on the pools underlying mortgage securities.  Also, we have added a team focused on the operational risks of loan origination and servicing practices, as well as constant pre-and post- purchase servicer surveillance.  As a result, we believe PIMCO is extremely well-positioned to assess and monitor the layered risks in these securities.

In the current environment of sharp home price decline where borrower home equity has been reduced, non-Agency mortgage securities carry historically high levels of default risk. PIMCO’s primary goal is to determine ultimate loss on a security or loan. We determine loss expectations by employing a proprietary loan level quantitative model in addition to an analysis of qualitative factors such as servicer practice and government housing policy impacts. The primary objective of this loan level analysis is to project the cumulative losses on a pool basis, as well as the prepayment and delinquency trajectories.

In addition to understanding the risks embedded in the pool of loans as well as the structure of the securities, PIMCO analyzes the macro effects of trends in the non-Agency MBS market.  We monitor the effects of mortgage credit  on national and regional home price appreciation, the availability of mortgage financing, origination trends affecting Agency MBS prepayments, and the balance sheet effects  on holders of non-Agency MBS.  Given the recent volatility of the sector and its far reaching impact outside of securitization markets, a robust mortgage credit research capability is key to understanding its linkages to other sectors as well as to the broader economy.

Risk Management & Analytics
Active MBS portfolio management requires a significant investment in analytics and risk management infrastructure. PIMCO has always devoted substantial resources to our proprietary mortgage analytics platform and has developed a full set of specialized tools. Our analytic arsenal includes two term structure models (Brace, Gatarek, Musiela and Black, Derman, Toy) as well as our proprietary PIMCO mortgage prepayment model.

PIMCO’s term structure models are tailored for LIBOR and swap rates, which are most consistent with the mechanics of the MBS market and the risk/valuation of securities in the sector. Our prepayment model incorporates historical behavior, stressing recent prepayment speeds, and is also sensitive to home price levels, which are a key driver of housing turnover. In addition, we compare our internally created term structure and prepayment model against publicly available Wall Street models daily. This side-by-side analysis is extremely useful in identifying securities with high model risk and also helps us to understand the possible range of outcomes for a security or a portfolio.

We also employ proprietary analytics to evaluate individual MBS with respect to their underlying characteristics, such as: rate, type, servicer, loan balance, origination date, borrower quality, housing prices, and spread to traditional loans at origination.

Our substantial analytics capabilities provide portfolio managers with what we feel is the best possible platform for the complexities of MBS risk management.

How To Invest

  • Separate Accounts
  • Mutual Funds
Article Disclaimer

1 Basel 1 and 2 are recommendations on banking laws and regulations issued by the Basel Committee on Banking  Supervision. Their purpose is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. PIMCO strategies utilize derivatives which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss.

This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

 

How To Invest

  • Separate Accounts
  • Mutual Funds

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No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.

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