For investors looking for high-quality income with the potential for significant total return, mortgage-backed securities (MBS) may be the answer. Securitized products are debt obligations issued by organizations such as Fannie Mae, Freddie Mac and Ginnie Mae whose cash flows are tied to the interest and payment of a group of mortgage loans. Agency MBS have low credit risk because they are backed by the US government. At the same time, current corporate MBS are yielding about 5.5 percent, said Jason Smith, senior portfolio manager in the global securitized products group at Neuberger Berman. “They look incredibly exciting,” he said. Several factors are at play. First, prepayment risk is at an all-time low, Smith said. Since so many Americans took out or refinanced mortgages when interest rates were at generational lows, few are willing to refinance. “You’re in an environment now where you’re much more confident about the cash flow you have behind the security,” Smith said. The 30-year fixed mortgage rate hit a 20-year high in October, just below 8 percent, and is currently at 6.87 percent, according to Mortgage News Daily. Meanwhile, fewer people will struggle to pay their mortgages thanks to low unemployment and homeowners enjoying rising home values that have boosted the equity in their homes, said Michael Kessler, senior portfolio manager. at Albion Financial Group. The national average loan-to-value ratio — which is the size of the mortgage relative to the value of the property — was 42% in the third quarter of 2023, according to CoreLogic. The average homeowner with a mortgage has more than $300,000 in equity since the date of purchase, the company found. So even if someone defaults, the mortgage lender should get all their money back when the home is sold, Kessler added. “It’s the low default risk because of the combination of low unemployment and strong income – and as a backstop, a huge amount of equity – that, for us, makes the fundamentals quite attractive,” he said. At the same time, current coupon MBS have an average spread of 140 basis points, Kessler pointed out. That’s because the Federal Reserve isn’t buying mortgages as it shrinks its balance sheet and banks aren’t buying as much as they used to, he said. “You’ve got those two holes in the buyer base, and that’s what’s pushed mortgage-backed spreads to wider levels than they’ve historically been,” Kessler said. All of this represents a big opportunity, experts said. Pramod Atluri, portfolio manager of fixed income at Capital Group, believes that corporate MBS could see significant total returns in the mid-7% range this year. Placing MBS in Your Portfolio In fact, Atluri believes that agency MBS is more attractive than corporate investment grade right now. As interest rate volatility eases and the curve flattens, corporate MBS could see 100 or 200 basis points of excess yields, he said. “You have a similar upside with much less downside, better liquidity, better rating [and] more resilience,” Atluri said. His firm’s Bond Fund of America (ABNFX) has 40% in mortgage-backed obligations, compared with about 30% in corporates, as of Dec. 31, according to the fund’s homepage capital. In addition, the company Mortgage-backed securities also trade defensively if the economic outlook worsens, he added. He expects an influx of retail buyers as money moves out of money market funds and into core bond funds. About 25% of core of bond funds is in mortgage-backed securities, according to Morningstar. big new buyer here and we’ll see if banks and foreign investors start to return to the market as the outlook for lower interest rates improves,” Atluri said. BlackRock is also bullish on MBS, calling them a good diversifier in a portfolio. which said it is very selective about where it puts money to work these days, also favors bonds over investment-grade corporate bonds. Both are high quality and generate income for the portfolio, but the differences in investment grade bonds are very limited now. “Mortgage-backed securities did not fare as well [as investment grade] last year,” said Wei Li, BlackRock’s global chief investment strategist. “We see it as overweight MBS versus underweight IG right now, having been overweight IG for a long time.” Albion’s Kessler also finds the mortgages more attractive on a relative basis vs. corporates, although it has exposure to both. The company has diversified exposure to MBS through exchanges. They’re attractive. They’re slightly below the threshold right now, so if rates fall and more people refinance, they will be protected from prepayment risk, he explained.rates are falling, he said.