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.
The Vanguard Mortgage-Backed Securities Index ETF also 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. VMBS has a 2.8 year duration and a 1.74% 30-day SEC yield.
The SPDR Barclays Mortgage Backed Bond ETF tracks a similar index of mortgage securities and comes with a 3.87 year duration and 2.32% 30-day SEC yield.
The iShares CMBS ETF takes on non-agency and agency commercial mortgage-backed securities. CMBS has a slightly higher credit risk exposure, but it also offers a higher 2.37% 30-day SEC yield and comes with a 4.2 year duration.
The iShares Core GNMA Bond ETF specifically targets mortgage-backed pass-through securities guaranteed by the Government National Mortgage Association, or Ginnie Mae. GNMA has a 2.69 year duration and a 1.93% 30-day SEC yield.
The FlexShares Disciplined Duration MBS Index Fund seeks to limit duration exposure to government agency issued MBS. Nevertheless, MBSD currently shows a similar duration profile to the other MBS-related ETFs at 3.07 years. The ETF comes with a 1.75% 30-day SEC yield.
Lastly, the First Trust Low Duration Mortgage Opportunities ETF is actively managed and focuses on low-duration MBS. The ETF can also include non-government-sponsored securities to generate income. LMBS has a 2.26 year duration and a 2.97% 30-day SEC yield.
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.