For investors looking for high-quality income with the potential for significant total return, agency mortgage-backed securities (MBS) may be the answer. The securitized products are debt obligations issued by agencies such as Fannie Mae, Freddie Mac and Ginnie Mae whose cash flows are tied to the interest and payment on a pool of mortgage loans. Agency MBS have low credit risk because they are backed by the U.S. government. At the same time, current agency MBS are yielding about 5.5%, said Jason Smith, senior portfolio manager within the global securitized products team at Neuberger Berman. “They look incredibly compelling,” he said. There are a number of factors at play. For one, prepayment risk is at an all-time low, Smith said. Since so many Americans obtained or refinanced mortgages when interest rates were at generational lows, few are inclined to refinance. “You are in an environment now where you are far more certain about the cash flows that you have underlying the security,” Smith said. The 30-year fixed-mortgage rate hit a 20-year high in October, just below 8%, and is currently 6.87%, according to Mortgage News Daily . Meanwhile, fewer people will have trouble paying their mortgages thanks to low unemployment and homeowners who are enjoying an increase in home values, which has boosted the equity in their homes, said Michael Kessler, senior portfolio manager at Albion Financial Group. The national average loan-to-value ratio — which is the size of the mortgage relative to the property value — was 42% in the third quarter of 2023, according to CoreLogic . The average homeowner with a mortgage has more than $300,000 in equity since the purchase date, the firm found. Therefore, even if someone defaults, the mortgage lender should get all of their money back when the home is sold, Kessler added. “The low default risk because of the combination of low unemployment and strong income — and as a backstop, a huge amount of home equity — that, to us, makes the fundamentals quite attractive,” he said. At the same time, current coupon MBS have an average 140 basis point spread, Kessler pointed out. That’s because the Federal Reserve isn’t buying mortgages as it shrinks its balance sheet and banks aren’t buying as much as they used to, he said. “You have these two holes in the buyer base and that is what has pushed spreads on mortgage-backed securities to wider levels relative to history,” Kessler said. That all adds up to a great opportunity, experts said. Pramod Atluri, fixed income portfolio manager at Capital Group, believes agency MBS could see significant total returns in the mid-7% range this year. Fitting MBS into your portfolio In fact, Atluri believes agency MBS are more attractive than investment-grade corporate right now. As interest-rate volatility comes down and the curve normalizes, agency MBS can see 100 or 200 basis points of excess returns, he said. “You get a similar upside with a lot less downside, better liquidity, better rating [and] more resilience,” Atluri said. His firm’s Bond Fund of America (ABNFX) has 40% in mortgage-backed obligations, compared to about 30% in corporate, as of Dec. 31, according to the fund’s home page. In addition, agency mortgage-backed securities also trade defensively if the economic outlook were to worsen, he added. “Therefore you can have this really, really big shift as people sell back the riskier stuff and move up in quality,” he said. In fact, he anticipates an influx of retail buyers as money moves out of money market funds and into core bond funds. About 25% of core bond fund holdings are in mortgage-backed securities, according to Morningstar. “This retail piece could be a big, big, big new buyer here and we will see if banks and foreign investors start coming back to the market as the outlook improves for lower rates,” Atluri said. BlackRock is also bullish on MBS, calling them a good diversifier in a portfolio. The firm, which said it is being very selective in where it is putting money to work these days, also favors the securities over investment-grade corporate bonds. Both are high quality and produce income for the portfolio, but spreads in investment grade bonds are very tight now. “Mortgage-backed securities didn’t do as well [as investment grade] last year,” said Wei Li, BlackRock’s global chief investment strategist. “We look at it as overweight of MBS versus the underweight that we currently have in IG, having been overweight IG for a long time.” Albion’s Kessler also finds mortgages more attractive on a relative basis over corporates, although he has exposure to both. The firm gets diversified exposure to MBS through exchange-traded funds. For Capital group’s Atluri, the “belly” — or middle — part of the 30-year mortgage curve is most attractive. They are currently slightly below par, so if rates fall and more people refinance, they’ll be protected from prepayment risk, he explained. The higher coupons, around 6%, are trading above par and could be at risk of prepayment if rates fall, he said.