Unlocking Value in Mortgage-Backed Securities Amid Geopolitical Storms and Fed Crossroads

The current high-rate environment, fueled by Fed caution and geopolitical tensions, has created a fertile landscape for investors to capitalize on volatility in mortgage-backed securities (MBS). With the Federal Reserve's July 2025 decision to hold rates steady at 4.25%–4.5%, and its cautious projections for only two cuts this year, uncertainty around monetary policy has surged. Meanwhile, tariff pressures from the Trump administration and energy market instability due to the Israel-Iran conflict are keeping inflation elevated. This dynamic offers a unique opportunity to deploy MBS strategies—whether through short-term trades or long-term yield plays—that can hedge against prolonged high-interest scenarios.

The Fed's Tightrope Walk and Its Impact on MBS

The Fed's July statement emphasized “two rate reductions by year-end,” but it also reduced its long-term rate projections by 0.6 percentage points, signaling a prolonged period of elevated rates. This ambiguity creates volatility in fixed-income markets, which can be exploited in MBS.

For income-focused investors, MBS offer a hedge against both rising and stagnant rates. Their fixed coupons provide steady cash flows, while their embedded prepayment protections—such as seasoned loans (issued years ago) or lower combined loan-to-value (CLTV) ratios—insulate portfolios from refinancing risks.

When rates are high and volatile, MBS with prepayment safeguards often outperform Treasuries, as their embedded options (e.g., caps on prepayment speeds) reduce duration risk.

Credit Quality Trends: A Mixed Picture of Strength and Vulnerability

Recent data reveals improving borrower profiles but lingering risks in certain segments.

• Credit Scores:
  The weighted-average FICO score for MBS borrowers rose to 737 in April 2025 from 723 in March, signaling tighter underwriting standards. Closed-end second mortgages (CES) saw an even sharper improvement to 738, while HELOC borrowers also gained ground. This bodes well for lower default probabilities.

• Debt-to-Income (DTI) Ratios:
  Combined DTI for MBS borrowers averaged 38.1% in April 2025, slightly higher than 2024 levels. While HELOC borrowers reduced their DTIs to 36.8%, prime mortgage borrowers showed modest increases. The Federal Reserve noted that household debt-to-GDP ratios hit 20-year lows, thanks to strong home equity and stable underwriting—key pillars of MBS resilience.

However, nonprime borrowers (e.g., auto and credit card holders) face elevated delinquency risks, with credit card delinquencies near 3%—a warning that over-leveraged borrowers could strain MBS collateral if economic growth slows.

Prepayment Protections: A Shield Against Rate Cuts

Prepayment risk—the chance that borrowers will refinance their mortgages when rates drop—has been muted by persistently high rates (~6.5%). With refinancing incentives “deeply out of the money,” prepayment speeds remain low, extending the life of MBS cash flows.

• Turnover as the Key Driver:
  Home sales, not refinancing, now dictate most prepayments. RiskSpan's Prepayment Model v3.7 highlights that delinquent loans (especially those with lower FICO scores) exhibit higher turnover as borrowers seek to avoid foreclosure. This creates opportunities in seasoned MBS pools, where loans are less likely to be refinanced.

• CLTV Trends:
  The weighted-average CLTV fell to 66.8% in April 2025, down from 67.8% in 2024. Lower CLTV ratios mean borrowers have more equity cushion, reducing the likelihood of default.

For traders, this stability makes MBS a short-term volatility hedge. For instance, during Fed meetings or geopolitical flare-ups (e.g., oil price spikes), MBS can provide ballast to portfolios.

Investment Strategies: Short-Term Volatility Plays and Long-Term Yields

Short-Term: Trade the Fed's Uncertainty

• ETFs and Futures:
  Use MBS ETFs like MBG or MBB to capture yield spreads during Fed-induced volatility. These funds often outperform during rate-cut speculation.
• Options Strategies:
  Consider put options on MBS ETFs ahead of Fed meetings to profit from price dips caused by hawkish signals.

Long-Term: Target Prepayment-Protected Sectors

• Seasoned MBS:
  Focus on pools issued in 2020–2022, which have minimal refinancing risk due to high original rates.
• Non-QM Loans (with Caution):
  While Non-QM (non-qualified mortgage) delinquencies rose in 2022–2023 vintages, their higher yields (6%–8%) can be attractive for aggressive investors willing to accept credit risk.

Risks and Considerations

• Geopolitical Risks: Energy price spikes could reignite inflation, prompting the Fed to delay cuts.
• Consumer Debt: Credit card utilization near 30% and rising mortgage delinquencies (1.03% in May 2025) require scrutiny of collateral quality.

Conclusion: MBS as a Prudent Hedge Against High Rates

In a world of Fed crossroads and geopolitical storms, MBS offer a compelling balance of income and stability. Their prepayment protections and improving credit metrics position them as a hedge against prolonged high-interest environments. Whether through short-term trades or long-term yield plays, investors can capitalize on this volatility—provided they prioritize sectors with strong equity cushions and seasoned collateral.

For now, the path forward is clear: favor MBS with prepayment safeguards, monitor DTI/credit score trends, and stay agile as the Fed's next move unfolds.