[This article appears in our November 2018 issue of ETF Report.]
Ten years ago, the world learned what a mortgage-backed security (MBS) was, as it was revealed that this once-obscure asset had played a starring role in the housing boom and subsequent crash.
The MBS hasn’t faded from use, however; far from it. In the years since the crash, the humble MBS has quietly become a mainstay in most major bond indices and bond portfolios, as a decade of anemic yields and high intra-asset correlations have sent investors searching for any investment that will give their bond portfolios a boost.
That’s a good thing, because despite their lingering bad reputation, MBSs—and MBS ETFs—actually have a lot to offer bond investors.
“I find it interesting that mortgage-backed securities aren’t more widely used in portfolios, because they have a lot of positive attributes,” said Stephen Laipply, BlackRock’s head of U.S. iShares Fixed Income Strategy.
Financial Crisis In Brief
Though MBSs gained widespread notoriety during the last financial crisis, the asset itself has been around since the 1960s.
This is how it works: Lenders resell their mortgages to another financial institution, which then bundles them together with other mortgages, making a securitized investment. When borrowers make payments on their loans, that generates steady, reliable income for the investors in the mortgage-backed security.
During the mid-2000’s housing boom, MBSs became popular with banks, insurers and hedge funds, which used them to offload mortgages from their books, therefore paving the way for ever-more loans. This instigated a wicked cycle of supply and demand that incentivized mortgage lenders to package less and less creditworthy mortgages into MBSs.
When subprime borrowers began to default on their mortgages, that turned the securities into which they’d been packaged into junk. Losses rippled through the financial market, and banks required massive taxpayer-funded bailouts to prevent the entire financial system from collapse.
However, investment in MBSs backed by government agencies like Ginnie Mae, Freddie Mae and Freddie Mac (known as “agency-backed MBSs”) has remained high, and trillions in agency-backed MBSs have been issued since 2007. In fact, today MBSs (both residential and commercial) constitute roughly 30% of the Barclays U.S. Aggregate Bond Index.
Appeal Of MBSs
The longevity of MBSs stems from several key benefits they provide investors. For starters, MBSs offer some of the highest yields of any fixed-income investment—a major selling point, given the past decade of low-to-zero bond yields. Currently, the average dividend yield for an MBS ETF is 2.79%, compared to the average yield of a Treasury ETF, which is 1.24%.
MBSs also exhibit low correlations to risk assets, like equities; their correlations are among the lowest of any fixed-income instrument, says Laipply: “Agency-backed MBSs offer many of the attractive diversification properties as U.S. Treasuries, but they yield more for a given duration range.”
In addition, MBSs—particularly agency-backed MBSs—are highly liquid, though less so than U.S. Treasuries. That liquidity is a must for institutional bond investors, says Ryan Issakainen, senior vice president and ETF strategist for First Trust Advisors.
“If you’re an investor for whom liquidity matters,” he said, “agency-backed MBSs offer liquidity in spades.”
Finally, adds Issakainen, the asset’s historical Sharpe ratios—a measure of risk-adjusted return—have been comparatively high.
“MBSs do have defensive characteristics,” he said. “But they can provide attractive returns relative to the rest of the fixed-income asset class.”
MBSs can be especially effective in an ETF wrapper, says Laipply, because thousands of individual issues can be packaged into one vehicle, offering one-stop-shop diversification and lowering trading costs overall.
“MBSs are operationally complex, especially in larger portfolios,” he added. But in an ETF, “all the payments come from the ETF, and investors don’t have to worry about the associated operational complexity.”
An ETF also provides extra transparency and liquidity, both of which the over-the-counter bond market can sometimes lack.
“[Individual] bonds don’t trade as frequently or with as much price transparency” as an ETF, said Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. “With the ETF wrapper, you get awareness of what you’re paying for. You can execute the trade when you want to, when the spreads are fair for you.”