Investors can gain exposure to a diverse pool of mortgage-backed securities through exchange traded funds, but investors should first understand how the investments work.
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.
One of the more notable entrants in the field of mortgage-backed securities ETFs is the Vanguard Mortgage-Backed Securities Index ETF (NYSEArca: VMBS).
“This fund delivers a higher yield than most of its peers that invest in agency MBS because of its relatively larger investments in Fannie Mae- and Freddie Mac-issued mortgage bonds” said Morningstar in a recent note. “Unlike Treasury bonds, these bonds are not explicitly guaranteed by the U.S. government, and they offer higher yields than Treasuries with a comparable term. The fund’s investments in Fannie Mae- and Freddie Mac securities represented roughly 70% of the portfolio as of March 2017.”
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.
“Vanguard’s index group has kept the fund’s performance close to its benchmark. From its November 2009 inception to March 2017, the fund produced an annualized return of 2.81%, lagging its benchmark by 0.04% on an annualized basis. This gap is less than its 0.07% management fee, which is among the lowest in the category. Over the same period, the fund’s absolute and risk-adjusted performance was in line with its average agency-mortgage fund peers,” according to Morningstar.
Credit risk is not a concern with VMBS as the ETF’s holdings are all highly rated. VMBS, which holds 552 bonds, has an average duration of 4.6 years and an average effective maturity of 6.8 years. The ETF charges 0.07% annually, making it less expensive than 92% of rival funds.
For more information on Fixed-Income ETFs, visit our Fixed-Income category.