Investors looking for some added yield with lower risk may want to consider mortgage-backed securities (MBS), an asset class made accessible via several ETFs, including the SPDR Portfolio Mortgage Backed Bond ETF (SPMB).

Home to nearly $844 million in assets under management, SPMB follows the Bloomberg Barclays U.S. MBS Index. With an expense ratio of just 0.06% per year, or $6 on a $10,000 investment, SPMB is one of the most cost-effective funds in its category.

MBS are created when an entity acquires a bundle of mortgages and then sells the securities. Most MBS are seen as “pass-through” security where the principal and interest payments are passed through the issuer to the investor.

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.

SPMB holds 864 bonds with a current yield of 3.01% and an option-adjusted duration of just 2.50 years, according to State Street data.

Getting Through Uncertainty

Despite the recent spurt forward that lifted global developed equities to all-time highs, investors will continue to grapple with an uncertain environment, slow growth, benign inflation, and low rates. Growth in 2019 is at its lowest since 2009, and the 2020 outlook is below the median and continues to be revised lower. Risks remain at all-time high and investors will still have to manage uncertainty, especially policy events upending sentiment globally.

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.

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.

There are some particularly specific risks associated with the asset class. For instance, borrowers can prepay mortgages, which poses a large risk in a falling rate environment since borrowers would typically refinance their mortgages at cheaper rates. Consequently, mortgage-backed securities investors would get their principal back before maturity and have to reinvest at the lower rates.

For more on alternative strategies, visit our Alternative Investment Channel.

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.

AGFIQ WEBCAST

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