Risks and Benefits of Mortgage-Backed Securities, ETFs

Investors can diversify a fixed-income portfolio with high-quality mortgage-backed securities and related exchange traded funds, but they should also understand the potential risks ahead.

For instance, the Vanguard Mortgage-Backed Securities Index ETF (NYSEArca: VMBS) tracks a group of investment-grade, high-quality mortgage-backed securities issued by U.S. mortgage agencies, like Ginnie Mae, Freddie Mac and Fannie Mae. [Government Bond ETFs Remain The Safer Play]

“As of October 2014, Agency MBS represented 20.7% of the Barclays U.S. Aggregate Bond Index. Because of their large representation within the benchmark, MBS may be used as a tactical investment when investors think mortgages are cheap relative to Treasuries and corporate bonds,” according to Morningstar analyst Thomas Boccellari.

Mortgage-backed securities are crafted through by combining variety of different individual mortgages into one security. If a bank or lender does not want to hold a loan on its balance sheets, it may decide to sell to one of the U.S. agencies to monetize the asset. In turn, the agency would combine the mortgages to create a mortgage-backed security and pay out interest and principal payments from the underlying assets to investors.

On the yield scale, investors can typically expect mortgage-backed securities to pay more interest than similar maturity Treasuries but less than similar maturity corporate debt. VMBS has a 4.3 year effective duration and a 1.35% 30-day SEC yield.

However, there are some particularly specific risks associated with the asset class. For instance, borrowers can prepay mortgages, which poses a large risk in a falling rate environment since borrowers would typically refinance their mortgages at cheaper rates. Consequently, mortgage-backed securities investors would get their principal back before maturity and have to reinvest at the lower rates.

“Because mortgages can be refinanced, they have call risk – the risk that borrowers refinance their mortgages,” Boccellari added. “While years of falling and low interest rates led to increased refinancing of existing mortgages, refinancing activity has slowed considerably over the past two years.”