Despite Headwinds, Mortgage-Backed Securities Diversify Income

Residential and commercial real estate have their own respective headwinds amid a high-interest rate environment. Still, for fixed income investors wanting to diversify their income before rate cuts happen, mortgage-backed securities (MBS) still remain an option.

The commercial property market has had its issues since the pandemic. Office buildings were replaced by a work-from-home culture that’s still pervasive among many companies. In the residential real estate market, high mortgage rates are pricing out prospective buyers. Sellers are more inclined to hold on to their homes with pre-pandemic level interest rates. And that is constricting supply. Of course, residential real estate is also nuanced according to the local market.

Record Issuance in 2023

“Home prices in most major property markets will rise modestly this year and next, according to a Reuters poll of housing specialists. [They] expected the shortage of affordable homes to persist for at least another two to three .years,” a Yahoo Finance report confirmed.

“In so many markets…supply has been quite constrained. You’ve had quite limited good supply because people are on low mortgage deals. They don’t really want to bring properties to the market and lose those deals,” said Liam Bailey, global head of research at Knight Frank. “The expectation rates are going to fall is now kind of baked in to where people think the market is going to go this year. And if rates don’t fall, then we have a problem.”

Despite this, the anticipation of lower interest rates in 2024 may have fueled record issuance in MBS in 2023, according to a National Mortgage News report. MBS assets can provide an opportunity to diversify monthly income. They could also help lock in yields at the current levels before the central bank loosens monetary policy. Real estate investment trusts (REITs) can offer exposure to MBS assets. But exchange-traded funds (ETFs) can also accomplish the same goal.

One Fund for MBS Exposure

One option worth considering is the Vanguard Mortgage-Backed Securities Index Fund ETF Shares (VMBS), which also offers a low expense ratio of 0.04%. To help minimize credit risk, VMBS holdings focus on MBS issued by government-owned corporations like Ginnie Mae and government-sponsored enterprises like Fannie Mae. Both help to provide liquidity in the mortgage market by buying and selling mortgages in the secondary market, so their role is essential.

Salient features of VMBS:

  • Seeks to provide a moderate and sustainable level of current income.
  • Invests primarily in U.S. agency mortgage-backed pass-through securities issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
  • Moderate interest rate risk, with a dollar-weighted average maturity of three to 10 years.
  • 30-day SEC yield of 3.91% as of March 1

For more news, information, and strategy, visit the Fixed Income Channel.