Among the fixed income exchange traded funds benefiting from the Federal Reserve’s lower for long policy are ETFs holding mortgage-backed securities, or MBS.
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).
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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.
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.