Big Yields From Mortgage Backed Security ETFs

October 30, 2018

Few ETFs, Lots Of Assets
Currently there are just eight MBS ETFs on the market, but together, they hold $21.6 billion in assets under management. (Note: Consistent with FactSet’s classifications, ETF.com splits listings for MBS ETFs across two ETF Channel categories: agency MBS ETFs and asset-backed ETFs, the latter of which covers blended and commercial MBS ETFs.)

More than half of the assets invested in MBS ETFs are concentrated into a single heavyweight: the $12 billion iShares MBS ETF (MBB). But the space also includes the $7.1 billion Vanguard Mortgage-Backed Securities ETF (VMBS) and the $1.67 billion First Trust Low Duration Opportunities ETF (LMBS).

There appears to be a price war brewing in MBS ETFs. Over the past year, more than half the $5.4 billion in new net investment flows that have entered MBS ETFs have gone into Vanguard’s VMBS ($2.9 billion), which is also 2 basis points cheaper than MBB.

But price isn’t everything. The cheapest MBS ETF is the SPDR Bloomberg Barclays Mortgage Backed Bond ETF (MBG), which costs 0.06%. Yet the fund remains comparatively small, with $192 million in assets under management. Over the past year, MBG has actually lost $10 million in outflows.

“Less trading volume and slightly wide spreads offsets the lower net expense ratio [in MBG],” explained Rosenbluth.

Interest Rate Risk Is Real
MBS ETFs do carry risks, of course—and not necessarily the risk that they’ll bring about another housing crash.

For starters, most MBSs available in an ETF package nowadays are agency-backed, meaning they have the same implied credit standing as U.S. Treasuries. Plus, lending standards were tightened post-housing crash, thus reducing the issuance of riskier mortgages from private-label firms. A strong U.S. economy and housing market haven’t hurt either.

However, like most bonds, mortgage-backed securities are exposed to interest rate risk. And MBSs can be hit on both sides of that equation, whether rates rise or fall.

If rates fall, mortgage borrowers tend to refinance their debt, and the mortgage-backed security may repay its principal more quickly, in something known as “prepayment risk.” That can result in the MBS exhibiting a shorter-than-expected life span and lower-than-expected return. To maintain their allocation, investors would need to reinvest in similar securities with lower yields.

However, if rates rise, then mortgage borrowers tend to hold off on refinancing their debt, and the MBS may repay its principal more slowly. That results in a longer-than-expected life span and a lower-than-expected return, since investors receive the lower coupon rate for a longer period of time.

This is known as “extension risk,” and what impacts it as much as a rise in rates is the speed with which that rise happens, says Laipply: “If rates rise gradually, then the extra yield you receive in holding MBSs relative to Treasuries may still benefit you. However, if they rise rapidly, then the incremental yield offered by MBSs may be overwhelmed by the rate rise.”

Active A True Value-Add
To mitigate these risks, some MBS investors rely on active management. Though most MBS ETFs track passive indexes, there are now two active funds as well: LMBS and the Janus Henderson Mortgage-Backed Securities ETF (JMBS), which launched in September.

Neither LMBS nor JMBS come cheap. LMBS costs 0.68%, while JMBS costs 0.35%. But at least in the case of LMBS, the higher price tag is offset by higher returns. Over the past 12 months, LMBS is the only MBS that has posted a positive return (0.78%); all other MBS ETFs have declined.

“When it comes to MBSs, active management allows us to find the best option-adjusted spread opportunities available in the market,” said Issakainen. “We can manage along the yield curve and along durations, and find opportunities where spreads are more attractive and manage extension risk as rates rise.”

 

Find your next ETF

Reset All