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.