The Fed might follow its September interest rate cuts with similar moves well into 2025. So some market participants are reassessing opportunities in bonds.
Much of that focus is being directed to Treasuries and corporate debt. But advisors and investors shouldn’t be quick to overlook mortgage-backed securities (MBS). That’s an asset class accessible in broad fashion via ETFs like the WisdomTree Mortgage Plus Bond Fund (MTGP ).
One reason MBS and ETFs like MTGP could appeal over the medium term is Fed loosening cycles often mute some prepayment risk associated with mortgage bonds. Prepayment risk is one of the biggest issues professional MBS traders evaluate. And when interest rates are declining, more mortgages may be refinanced. And cash can be directed elsewhere rather than moving to pay off mortgages in full.
Timing for MTGP Could Be Right
Regardless of asset class, market timing is difficult. On the other hand, environments marked by Fed easing are typically conducive to owning bonds, including MBS. ETFs such as MTGP could reward income investors in the months ahead if the Fed turns aggressive with rate cuts.
“If the Fed decides to become aggressive and cut rates faster than expected, it could trigger what’s known as a ‘refi wave,’” noted David Varano, director of business development at ICE. “That’s when people pre-pay their mortgages en masse during a relatively short period. All that pre-payment activity during a relatively short amount of time can create disruption. In the capital markets, new issuance rises as older bonds are retired either partially or in [full. That would leave] investors flush with principal that needs to seek reinvestment opportunities.”
A potential refi wave is relevant to investors considering MTGP. That’s because there’s likely broad appetite for refinancing mortgages. ICE estimates there are currently 4.2 million mortgages in the market today that were originated at interest rates of 6.5% or higher.
Potential Catalyst for MTGP
Should the Fed continue lowering rates, it would compel borrowers to refinance. That would dampen prepayment risk in the MBS market, while potentially stoking a raft home buying. That could also be a catalyst for MBS and MTGP.
“That’s good news for [borrowers. That’s] because it enables them to pay less money to their mortgage every [month. And presumably they could save] or allocate the money elsewhere. That kind of consumer spending can give the economy a boost. Homes sales might increase as well, should more inventory come onto the market if borrowers with low mortgage rates feel less of a ‘golden handcuff’ mentality,” added Varano.
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