Opportunities in Mortgage-Backed Securities (MBS)
We conduct intensive, fundamental research on MBS securities, similar to our approach to corporate credit research. In MBS-related research, the key to security valuation is understanding the propensity of the homeowners underlying the mortgage loans to prepay their loans across a broad range of environments, and the effect of this prepayment profile on the security’s current valuation and prospective total return.
As a result of the rise in interest rates and the flattening of the yield curve, the yield premiums of slightly seasoned, deep-discount, 30-year MBS grew; as our analysis indicated that they offered attractive yields and good total return potential versus other high quality, intermediate-duration alternatives, we added to the Fund’s holdings. We also introduced a new type of Agency MBS to the Fund—slightly seasoned, 30-year, Hybrid ARMs. These securities combine attributes of normal fixed-rate mortgages with those of ARMs. Hybrid ARM borrowers pay a fixed rate on their loan for the first several years (3, 5, 7 or 10 years, depending upon the loan type); thereafter, the rate on the loan resets annually at a fixed margin to either LIBOR2 or U.S. Treasury yields. We have focused on “5/1 ARMs” (rate is fixed for the first five years, then resets annually for the remaining 25 years) that are trading at discounts to par as we believe they offer attractive expected returns relative to other high-quality, short-duration alternatives over a broad range of scenarios.
