Fixed income investors looking for some added yield without excessive risk should evaluate mortgage-backed securities (MBS) and the related ETFs, including the SPDR Portfolio Mortgage Backed Bond ETF (SPMB).
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.
“Mortgage-backed securities (MBS) are one of the largest sectors within the bond market, with $6 trillion of market value. This is second only to US Treasuries in broad-based indexes, both in terms of notional value and weight (29%),” said Matthew Bartolini, head of SPDR Americas Research, in a recent note. “Despite this size, investment portfolios are decidedly underweight the bond sector—even though its investment profile has historically been attractive.”
Good Trade Timing
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. As such, credit risk is minimal with SPMB.
The $2.14 billion SPMB holds 942 bonds with a current yield of 3.06%, according to issuer data. While SPMB’s benefits are clear, including low credit risk, it’s evident MBS is an overlooked corner of the fixed income ETF market.
“ETFs categorized as mortgage-backed make up only 5% of the overall bond ETF market, much lower than the market share of targeted government and corporate bond ETFs, at 17% and 19% respectively,” said Bartolini. “In fact, the market share of MBS is the same as inflation-protected strategies, a more niche area of the market.”
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.
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As SPMB indicates, there’s a tempting MBS yield proposition.
“Mortgages have historically earned a premium over Treasuries and the broader Agg. Since 1997, the average yield for MBS was 4.5% compared to 3.2% and 4.1%, respectively,” said Bartolini. “This average 43% and 11% premium is not only witnessed on a straight-line historical average that can be skewed by outliers, but it is also evident with historical persistency.”
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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.