Mortgage-backed securities (MBS) are coming back into the limelight amid the White House’s plan to privatize Fannie Mae and Freddie Mac. However, that effort could face a tough go of it in Congress.
“Fannie and Freddie do not make home loans,” according to the New York Times. “They buy mortgages from banks that originate them, then securitize them and sell those mortgage-backed securities to investors. That process is meant to reduce mortgage rates by spreading the risk of default and help underserved Americans buy homes.”
Investors looking for broad-based exposure to MBS as an asset class can consider ETFs, such as the FlexShares Disciplined Duration MBS Index Fund (NasdaqGM: MBSD).
MBSD, which turns five years old later this month, holds 357 bonds and has a weighted effective duration of 3.01 years, according to issuer data, giving it one of the lower durations in this category.
MBSD Seeks Investment Results
MBSD “seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the ICE BofAML®, Constrained Duration US Mortgage Backed Securities Index,” according to FlexShares.
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 “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. MBSD has a 30-day SEC yield of 2.27%.
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 information on Fixed-Income ETFs, visit our Fixed-Income category.