With the Federal Reserve continuing its efforts to normalize U.S. monetary policy, plenty of asset classes could be affected by those plans, including mortgage-backed securities (MBS) and exchange traded funds such as the iShares MBS ETF (NYSEArca: MBB).
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.
“A normalization of the Fed balance sheet would likely involve eliminating most of the central bank’s MBS holdings over time,” said BlackRock in a recent note. “MBS valuations today reflect anticipation that this process will go smoothly—as well as benign expectations that rates will rise only gradually. These expectations are not limited to MBS—credit spreads as well stand at or close to post-crisis tight levels. This leaves little margin for error, we believe, and is reflected in our neutral stance on MBS and preference for higher-quality credit in today’s environment.”
Other MBS ETFs include the 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).
“However, this is the first time the Fed has ever used asset reductions as a tightening (or normalizing) tool, making the actual impacts uncertain. As such, the Fed is likely to proceed cautiously with its unwinding,” according to BlackRock.
For more information on Fixed-Income ETFs, visit our Fixed-Income category.