Investors can gain exposure to a diverse pool of mortgage-backed securities through exchange traded funds, but people should first understand how the investments work.
Mortgage-backed securities, or MBS, came out of the financial crisis with a black eye, but the asset class is making a comeback as more investors tap the MBS market through ETFs to diversify a fixed-income portfolio, writes Daniel Kurt for Investopedia.
For instance, ETF investors have a number of options to choose from, including the iShares MBS ETF (NYSEArca: MBB), Vanguard Mortgage-Backed Securities Index ETF (NYSEArca: VMBS), SPDR Barclays Mortgage Backed Bond ETF (NYSEArca: MBG), iShares CMBS ETF (NYSEArca: CMBS), iShares Core GNMA Bond ETF (NYSEArca: GNMA), FlexShares Disciplined Duration MBS Index Fund (NasdaqGM: MBSD) and First Trust Low Duration Mortgage Opportunities ETF (NasdaqGM: LMBS).
To start off, investors should know what they are getting themselves into. MBS are created when an entity acquires a bundle of mortgages and then sells the securities. Most MBS are seen as a “pass-through” security where the principal and interest payments are passed through the issuer to the investor. [Risks and Benefits of Mortgage-Backed Securities ETFs]
Most funds typically trade securities taken from the three prominent agencies – Ginnie Mae, Fannie Mae and Freddie Mac. These agency securities usually come with high-quality ratings and are explicitly or somewhat implicitly backed by the U.S. government.
While MBS may offer modestly higher yields relative to U.S. Treasuries, the mortgage-backed bonds are exposed to prepayment risk – if rates dip before the security’s maturity, a homeowner can refinance debt, causing an investor to get back the principal early and reinvest it in a security with a lower yield.
ETFs provide investors a way to access a large, diverse pool of MBS without large initial payments. For instance, an investor can buy one share of MBB, which tracks 258 different securities, instead of investing $10,000 or more in a required commitment.
The iShares MBS ETF is the largest MBS-related ETF on the market. MBB includes mortgage securities from government sponsored entities like Ginnie Mae, Fannie Mae, and Freddie Mac. The ETF shows a 3.21 year duration and a 1.94% 30-day SEC yield.