Rising Mortgage Rates Hit These ETFs

Higher mortgage rates are on the surface bad for bond ETFs, but varying strategies are impacted differently.

Mortgage rates hit seven-year highs this month, making troubling headlines for would-be home buyers shopping for that 30-year mortgage, but also signaling tough times for fixed-income ETF investors in general.

Directly in the spotlight is the iShares MBS ETF (MBB), which consists of a portfolio that’s currently allocated roughly 75% to mortgage-backed securities (MBS) and 25% to cash. The $11.75 billion fund has seen net asset inflows totaling about $266 million so far in 2018, but earlier this month faced net redemptions of $321 million.

Share prices of MBB are currently trading at lows not seen since March 2017.

MBB’s main competitor, the $5.25 billion Vanguard Mortgage-Backed Securities ETF (VMBS), is also impacted. The fund currently allocates about 86% of its portfolio to securities, and 13% to cash, according to FactSet data. The $207 million SPDR Bloomberg Barclays Mortgage Backed Bond ETF (MBG) is 96% in MBS and 4% in cash.

These ETFs are in the red this year in terms of performance:

Unfortunately for fixed-income ETF investors, the rise of mortgage rates is only part of the troubling picture. The multiyear milestone for mortgages comes as Treasury yields are also inching higher—the 10-year is up more than 0.60% year-to-date, now above 3%. MBS and Treasurys tend to be highly correlated, and as yields rise, prices typically fall.

Aggregate bond ETFs tracking or orbiting the popular Bloomberg Barclays US Aggregate Bond Index help show that the pinch this year is stemming from more fronts than mortgages alone.

Aggregate Bond ETFs

These funds own various segments of the bond market, and in 2018, every segment from municipals to MBS to investment-grade corporates to Treasurys is in the red.

The Agg index is about 28% allocated to MBS. That means funds tracking it, such as the $55 billion iShares Core U.S. Aggregate Bond ETF (AGG), the $5 billion Schwab US Aggregate Bond ETF (SCHZ) and the $2.8 billion SPDR Portfolio Aggregate Bond ETF (SPAB) all carry more than a quarter of the portfolio in MBS.

The $36 billion Vanguard Total Bond Market ETF (BND), which tracks the Bloomberg Barclays U.S. Aggregate Float Adjusted Index, has about 21% of the portfolio in MBS, according to FactSet data. These ETFs, too, are trading at lows not seen since spring 2017, extending losses year-to-date:

But MBS could be one of the most resilient parts of these portfolios this year despite the rise in rates. A look at actively managed bond ETFs seeking to outperform the Agg show that these funds are achieving that outperformance in part by allocating more heavily to MBS, which, while down for the year, isn’t pressured as much as other segments of the bond market.

Active Aggregate Bond ETFs

No aggregate bond ETF is more exposed to MBS than the SPDR DoubleLine Total Return Tactical ETF (TOTL). TOTL has an allocation that’s almost twice that of the Agg—53% of TOTL is currently tied to MBS.

TOTL, managed by Jeffrey Gundlach’s DoubleLine Capital, has a broad mandate allowing it to invest in various fixed-income sectors globally. The ETF is outperforming the Agg as well as its main actively managed competitor, the PIMCO Active Bond ETF (BOND), which has about 34% of its portfolio tied to mortgage. (Both are outperforming the Agg this year).

For perspective on the relative strength of MBS in the fixed-income universe, consider the performance of other bond segments using ETFs as proxy: investment-grade corporates as measured by the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD); Treasurys as measured by the iShares 20+ Year Treasury Bond ETF (TLT); and zero-coupon bonds, as measured by the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ZROZ).

Their losses are even steeper this year, making MBS a relatively bright spot despite the negative headlines on mortgage rates.

Charts courtesy of StockCharts.com

Contact Cinthia Murphy at [email protected]