Strategic Mortgage-Backed Securities Plays Amid Expected BoE Rate Cuts

The Bank of England's (BoE) delayed but anticipated rate cuts to 4% in August and 3.75% by November 2025 are creating a unique opportunity for investors to capitalize on mortgage-backed securities (MBS). With inflation expected to peak at 3.75% in Q3 before receding, and geopolitical risks like Middle Eastern conflicts and U.S. tariffs weighing on economic growth, the BoE's gradual easing provides a catalyst to stabilize housing liquidity and reduce prepayment risks. This environment positions government-backed MBS funds or ETFs as prime candidates for risk-adjusted returns. Here's how to navigate this shift.

Why Rate Cuts Benefit MBS Investors

The BoE's June hold—despite a 6-3 MPC split—signals its commitment to a “gradual and careful” path. The delayed cuts, however, mean markets have already partially priced in August's 25-basis-point reduction. The subsequent November cut to 3.75% will further alleviate refinancing pressures. When rates fall, homeowners are less incentivized to refinance, reducing prepayment risk for MBS investors. This dynamic stabilizes cash flows and supports MBS valuations, which had been pressured by earlier uncertainty.

Historically, MBS outperform during rate-cut cycles. For instance, during the 2019 BoE easing, UK MBS yields compressed by ~50 bps relative to Gilts, driven by reduced prepayment risk. A similar trajectory is likely now, though geopolitical oil price volatility adds a layer of caution.

Reduced Prepayment Risk: A Key Catalyst

Prepayment risk—the risk borrowers pay off mortgages early—plagues MBS investors when rates drop. But if the BoE's cuts are gradual and follow a predictable path, refinancing activity will moderate. For example, a borrower with a 4.25% mortgage might hesitate to refinance to 3.75%, especially amid weak economic growth. This stability creates a “sweet spot” for MBS investors: higher coupon rates on existing securities paired with predictable cash flows.

Government-backed MBS, such as those issued by UK housing agencies, are particularly attractive here. These securities often have explicit guarantees, reducing credit risk while benefiting from the broader MBS rally.

Focus on Government-Backed MBS

Investors should prioritize MBS tied to government-backed programs, such as the Council of Mortgage Lenders (CML) index-linked securities or ETFs like the iShares UK Mortgage-Backed Securities ETF (IGLT). These instruments offer exposure to a diversified pool of mortgages with lower default risk.

As of June 2025, IGLT has outperformed Gilts by ~2.5% year-to-date, a trend likely to continue if the BoE's rate cuts materialize. Meanwhile, the iBoxx UK MBS Index shows a 1.8% yield advantage over comparable Gilts, reflecting reduced duration risk amid expected rate declines.

Navigating Geopolitical Risks

The Middle East conflict and U.S. tariffs remain wildcards. A spike in oil prices could reignite inflation, forcing the BoE to delay cuts. Investors should monitor breakeven inflation rates (e.g., UK 5-year inflation-linked bonds) and oil price trends. If Brent crude stays below $85/barrel, the BoE's path remains intact.

Diversification is key. Pair MBS exposure with short-term Treasury bills or inflation-linked bonds (like the iShares UK Inflation-Linked Government Bond ETF) to hedge against unexpected volatility.

Investment Strategy: Position Before the August Cut

Timing matters. The August meeting is critical. If the BoE delivers a 25-bps cut, MBS spreads will tighten further, rewarding early entrants. Investors should allocate 5-10% of their fixed-income portfolio to MBS via ETFs or mutual funds like the Fidelity UK Mortgage Fund. Avoid leveraged MBS or non-agency securities, which carry higher credit risk.

The November cut to 3.75% will solidify the trend, making November an ideal time to scale positions. Monitor the BoE's inflation forecasts and MPC voting patterns; a widening dovish majority post-August could accelerate the rally.

Conclusion

The BoE's rate cuts are a double win for MBS investors: reduced refinancing pressure stabilizes cash flows, while lower yields boost valuations. Government-backed MBS and ETFs offer a balanced risk-reward profile, especially if geopolitical risks remain contained. Investors who act now—before the August decision—can secure a position in an asset class poised for rebound. As the BoE's caution turns to action, MBS are set to outperform in a low-yield world.

Stay ahead of the curve.