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The MBS Income Factor

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Factor based investing has become commonplace in Equities, with ETFs available for many factors. More recently, numerous fund managers have also started using equity factors, such as “Momentum”, “Value”, “Size”, “Quality”, “Yield” etc. for Fixed Income portfolio construction and investing.

Since 1994, we have been using what would today be called an “Income Factor” to identify MBS with high returns, and have built an MBS strategy that uses this factor for portfolio construction.

Our core insight has been that MBS is not a “Fixed Income” product, but is a “Variable Income” product.

What is “MBS Income”?

For many market participants who have been trained to believe that all bonds are “Fixed Income”, the concept of MBS as “Variable Income” is foreign, to say the least. This insight, that MBS are “Variable Income Securities”, is arrived at by deconstructing the core concept of Total Returns.

Total Returns are typically attributed to two factors – Return from Price Change and Return from Income. For most bonds, such as corporate bonds or US Treasuries, the Return from Income is correctly understood to be a function of coupon interest and price, and is approximated by “Yield”. Variation in returns for Fixed Income bonds usually arise from differences in Return from Price Change, and most investors focus on Price Change, either through active duration management, or by looking for spread compression.

MBS returns derive from many additional factors besides the returns from coupon or price change. The cashflows in MBS are not stable, either creating additional return, or offsetting return from interest, as these additional factors impact MBS cashflows dramatically, both positively and negatively.

Many investors think that prepayments and credit losses are the extent of cashflow variation in MBS, and much effort is expended in MBS Research to identify and model the loan characteristics that impact MBS prepayments or borrower credit. Examples of such characteristics are loan sizes, FICO scores, geography, type of loan, loan size, LTV, size of servicer, shelf name, shelf type (bank or third party originator), seasonality, etc.

I spent much of the early 1990s as head of the MBS Strategies group at Nomura trying to improve MBS models and explain MBS return volatility through identifying and modeling additional factors, as MBS models were not good predictors of MBS returns. As an industry, we did not (and still do not) even have consensus on the duration of our benchmark Agency MBS duration. It is during this period that I had the epiphany that MBS is not Fixed Income, and developed the framework and tools to systematically identify MBS Income.

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