What the Fed’s tapering means for mortgage-backed securities

Seb Oliver / Getty Images
Seb Oliver / Getty Images

Nearly a decade after the financial crisis, the Federal Reserve (Fed) is taking clear steps to 'normalize' its monetary policy. In addition to raising rates, it is also reducing the size of its balance sheet by curtailing its bond buying program. Think of this as a good sign that economy is now healthier, and emergency accommodative action is no longer needed. The bond buying program, known as Quantitative Easing (QE), was designed to lower longer-term borrowing rates by buying U.S. Treasuries and agency mortgage-backed securities (MBS) . Mortgage-backed securities are bonds whose cash flows are backed by individual mortgage loans. The bonds are issued by government-sponsored entities, such as Fannie Mae, Freddie Mac and Ginnie Mae, which provide a government guarantee of the principal payments that the bonds make. The Fed chose to buy these bonds since they are considered safe from credit risk, and this decision directly resulted in lower mortgage rates. The QE program bought about 25% of the new MBS supply each year since 2009. To avoid disrupting the bond markets, the Fed's normalization plan does not involve selling bonds. Instead, the Fed will decrease its reinvestment of the principal payments it receives and only reinvest when payments exceed its set caps. At first it is capping the reinvestment amount at $6 billion per month for Treasuries and $4 billion for MBS. Then every three months, these amounts will be increased by another $6 billion and $4 billion, respectively, until they reach $30 billion for Treasuries and $20 billion for MBS per month in September 2018. Meaning, the Fed will reinvest less and less as caps rise, allowing their holdings to decline. Transparency about the changes should allow both markets to continue to function smoothly.

Outlook for MBS

Yields on mortgage-backed securities

Sharpe ratio
MBB Karen Schenone , CFA, is a Fixed Income Product Strategist within BlackRock's Global Fixed Income Group and the newest contributor to The Blog . Learn more about how consistent investment performance and low fees are critical to achieving your fixed income goals in today's environment.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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