Mortgage refinancing and effects on bond mutual funds

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Mortgage refinancing and effects on bond mutual funds

Post by ny10036 »

I have a "how does the sausage get made" question about bond mutual funds (and ETFs) and all the mortgage refinancing that's going on right now due to the fall in interest rates.

I only have a rudimentary understanding of the pipeline from mortgage to bond mutual funds, and it goes like this: homebuyer gets a mortgage from bank, bank sells (or just hands over?) mortgage to Fannie Mae etc, Fannie Mae bundles a bunch of the mortgages and securitizes it into a bond, then a bunch of mutual funds purchase it at some price.

I know I have some of these securities in my own accounts, because I hold VBTLX and it states in its summary that "the fund invests in [...] mortgage-backed securities of all maturities "

I assume the securities from pay a monthly coupon, because most people pay their mortgage monthly which includes principal and interest, so I guess the majority of this chunk ends up in these mutual funds every month.

But (1) what happens to this mortgage backed security if a large chunk of the borrowers refinance at a lower rate and pay off their current mortgage? (2) what happens to the price and monthly dividend payment of the mutual funds?

I know VBTLX is HUGE, so even thousands of borrowers refinancing won't create noticeable movement in its price or yield.

So here's an extreme hypothetical that occurs in a vacuum. 100% of the borrowers in a bond refinance at the same time. And a bond mutual fund only holds two bonds, the one that was completely paid off early and another one chugging along as usual. What happens to the bond? And what happens to the mutual fund?
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Re: Mortgage refinancing and effects on bond mutual funds

Post by grabiner »

A mortgage payoff has the same effect as calling a bond. The net effect is that mortgage-backed bonds gain less than other bonds from falling rates, because owners are more likely to refinance.

If you own a 4% bond, you receive 4% of the par value as a dividend every year. But if the bond is callable at par, and new bond rates ate 3%, the issuer may pay you the entire par value; if you buy the new bond, your dividend return will be only 3%.

If you own a mortgage at 4%, you receive 4% of the principal as interest every year, and a small amount of principal payment. But if rates drop to 3% and the homeowner refinances, you get back all the principal; if you buy the new mortgage, your interest return will be only 3%. This is a risk of mortgage-backed bonds.
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Re: Mortgage refinancing and effects on bond mutual funds

Post by JBTX »

Mortgage back bonds tend to have a little bit higher rate than comparable conventional bond. This is because there is the risk that the borrower pays it off early or refinances. At that point the bond holder will get their principal back. They could reinvest it in another mortgage, but likely at a lower rate.

If you look at the yield of a intermediate term treasury bond and a government backed mortgage intermediate bond fund, the mortgage bond fund will be around 1% higher.

With a conventional treasury, if rates go down, your bond value goes up. With a mortgage backed security, it won't go up as much, because some mortgage holders will likely refi.
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