By Ian Salisbury

It isn't easy to find bargains in the bond world right now. Funds that target mortgage-backed securities are one way to snag a little extra yield, without adding a ton of risk.

After years of struggles, bonds are delivering solid returns -- the iShares Core U.S. Aggregate Bond exchange-traded fund has returned 6.8% in 2025, on track for its best showing since 2020. But as with the stock market, many bonds are richly priced. Both investment-grade and corporate bonds are trading at historically tight spreads, meaning they don't offer much yield above what investors could earn in Treasury bonds.

Meanwhile, mortgage-backed securities, which make up about 20% of the U.S. bond market, boast competitive yields and essentially zero credit risk. These securities, which bundle residential mortgages, may evoke memories of the 2008-09 financial crisis. Today, however, the vast majority are so-called agency bonds, backed by a government-sponsored entity like Fannie Mae or Freddie Mac. From a practical perspective, that means they offer a credit profile similar to Treasuries.

The mortgage sector is having a strong year. The iShares MBS ETF, which yields 4.2%, has delivered a 7.6% total return, edging out the rest of the bond market. MBS spreads -- the premiums mortgage bonds pay over Treasuries -- have narrowed recently, thanks to that strong performance. But the MBS still yield about one percentage point more than Treasuries with similar durations, in line with their historical average.

Considering corporate bond spreads, that makes MBS comparatively attractive, according to Pimco managing director Mike Cudzil. "There's still plenty of decent value there," he says. "And there's still room for agency mortgages to outperform going forward." The firm's flagship Pimco Total Return fund has 33% of its portfolio invested in agency mortgages, compared with about 25% for its benchmark.

The MBS opportunity is a result of recent bond market dynamics. When Covid hit in 2020, the Federal Reserve slashed interest rates and began buying billions of mortgage bonds, a move that shored up MBS prices and held down yields.

When inflation spiked two years later, the central bank reversed course, hiking rates and halting bond purchases. That served up a double whammy to the MBS market. Not only was the Fed no longer a buyer, but major U.S. banks -- which also soaked up billions of MBS each quarter -- were caught off guard and also stepped back from the mortgage market. Mortgage spreads jumped from around a quarter percentage point in early 2021 to two percentage points two years later, according to Bloomberg data.

In recent quarters, opportunistic mutual funds and pension funds have been gobbling up excess supply. Meanwhile banks -- which like mortgage-backed bonds because of their favorable capital treatment -- are slowly coming back. Bank MBS holdings increased 2.4% year over year in the first quarter, according to Ginnie Mae's most recent market report. It's a trend that should continue thanks to a steepening yield curve, which makes holding MBS more attractive to banks, says Walt Schmidt, FHN Financial's senior vice president of mortgage strategies.

While demand for mortgage-backed securities grows, supply is expected to remain relatively tight. Issuers sold $1.3 trillion of mortgage bonds in the first nine months of 2025, according to Sifma, a trade group. That is on track to easily surpass 2024's $1.6 trillion, but nowhere near the $4.6 trillion issued in 2021. One big reason: With 30-year mortgage rates stuck above 6%, few homeowners are willing to sell or refinance. "If the housing market were going gangbusters, you would see more supply, that's just not the case right now," says Jake Remley, co-manager of the Harbor Disciplined Bond ETF, which is also overweight mortgage bonds.

MBS do come with one special risk. While most mortgages come with a 30-year term, few homeowners remain in place for three decades. When homeowners do move or refinance, bondholders can face early repayment -- and the prospect of having to reinvest their principal at lower rates.

The risk is highest when interest rates are trending down, as they are right now. Still, with mortgage rates twice as high as they were just a few years ago, the danger seems remote. "A huge portion of the market is at very low interest rates," says Remley. "It would take a very large move in interest rates to get down to where many of those folks would be interested in refinancing."

Write to Ian Salisbury at ian.salisbury@barrons.com

To subscribe to Barron's, visit http://www.barrons.com/subscribe

(END) Dow Jones Newswires

November 07, 2025 21:31 ET (02:31 GMT)

Copyright (c) 2025 Dow Jones & Company, Inc.