Mind the Gap

{Q} When were mortgage-backed securities at their peak, and where are they now?

{KIRBY} If you look at spreads in ’06 before the subprime headlines really began to hit the market, investors were looking for ways to enhance returns in a very tight spread environment. Valuations and leverage were really pushed to an extreme as investors were trying to eke out extra return. Spreads began to widen in the early part of this year when the headlines came out on subprime, and the Federal Reserve Bank continued to raise rates, and we saw the housing market start to weaken.

[Mortgaged-backed] spreads compared to Treasuries at their tightest were inside of 100 basis points. [One percentage point is 100 basis points.] This year, we actually saw a peak of about 200 basis points, so it’s fair to say that you’ve seen a doubling of spreads.

{Q} Have prepayments of home loans accelerated or decelerated?

{KIRBY} That is an effect that we have been spending a lot of time studying. As the housing market has slowed, we would expect that prepayments are going to slow very dramatically.

{Q} What does this mean for a regular investor?

{KIRBY} A couple of things. I think there’s a trade-off between the possibility that lower interest rates and slower prepayments will make these mortgages more sensitive to increases in interest rates, which could trigger losses of market value on these securities. Nevertheless, the valuations on the underlying assets are extremely attractive relative to Treasuries, so there’s a trade-off there. My view is that an increase in price could result if spreads tighten—meaning that investors perceive less risk in these bonds—which would more than compensate for a loss in market value from higher interest rates, should that occur. [Bond prices move in the opposite direction of interest rates.]

{Q} Is this a good time for regular investors to put a little money into mortgage-backed securities?

{KIRBY} I think that from a valuation standpoint, they’re very attractive assets. From a level of yield—the interest rate paid on the bonds—it’s harder to argue that they’re all attractive. So you probably would want to scale investments cautiously because the assets are attractive. But interest rates in the fixed-income market as a whole are on the low side, so I would caution folks about getting too aggressive.