Mortgage backed securities have long been feared by investors
across the globe. Especially after the U.S subprime crisis back in
mid 2007/2008 where these highly complex instruments were
unregulated. However, things have changed a lot since then.
With more stringent risk management principles in place and the
market seeing more rigorous regulations since the 2008 debacle, the
solvency and credit quality of the mortgage financing companies and
their loans have improved immensely.
Favorable economic data coming in domestically and from abroad
has resulted in an increase in corporate activities leading to
higher income and consumption in the U.S markets. As the demand for
residential and commercial real estate rises, likewise mortgage
financing companies are bound to see an increase in their asset
books in the near future. (see
Top Three Mortgage Finance ETFs
Structure of MBS
A mortgage backed security is created by a process known as
It is a process by which illiquid loans are transformed into
tradable securities. In case of MBS, the underlying loan is a
mortgage loan. The loans are pooled together and act as a single
debt security. These securities are then rated based on the credit
quality of the underlying pool of loans.
On the basis of the ratings, coupons are assigned, with higher
coupons assigned to lower rated securities and vice versa. (read
Top Three High Yield Financial ETFs
). Lastly they are sold to the public at large and are traded in
the open market. By using this process, the highly illiquid
mortgage loans can be easily traded in the form of liquid debt
Most MBS are
"pass through securities"
guaranteed by Govt. Sponsored Enterprises (GSEs). These include
Ginnie Mae, Freddie Mac and Fannie Mae. The cash flow streams
arising out of the mortgage loan repayments (principal plus
interest) are "passed through" to the investors purchasing the
It is prudent to note that apart from the cash flow streams,
lots of other risks are also pushed on to investors as well. Among
the biggest concern to investors should be;
interest rate risk
Current scenario in MBS market
Real estate demand is finally starting to turn around. In fact,
sales of existing homes in February marked the best second month of
the year for the industry prior to the broad market slump.
Additionally, investors also saw the first year-over-year price
increase in home values since November of 2010.
If the interest rates remain low, but start to slowly creep
higher, there will be a significant increase in the demand for
mortgage loans resulting in creation of more asset based
securities, possibly increasing the pool of high quality assets in
the space. (read
Time For A Commercial Real Estate ETF?
For investors looking to make a play on the broad space, there
are several options in the ETF world. These ETFs employ a basket
approach of investing across various investment grade mortgage
backed securities with varying maturities, ensuring that credit
risk is pretty much entirely diversified away. As a result, any of
the following three ETFs could be great picks to play this slowly
iShares Barclays MBS Bond ETF (
Launched in March 2007, MBB seeks to replicate, before expenses,
price and yield performance of the
Barclays Capital U.S MBS index
. The market capitalization weighted index measures the performance
of the investment grade agency mortgage backed "pass through"
These securities are generally
fixed rate securities
of the Govt. National Mortgage Association (
), Federal National Mortgage Association (
) and Freddie Mac (FHLCM). The Index is reviewed and rebalanced on
a monthly basis.
With total assets of $4.87 billion and average daily volume of
365,106 shares, it is by far the biggest and most popular name in
the MBS ETF space. From a sector perspective, traditional 30 year
mortgage securities comprise the bulk of the assets at 56.14%,
followed by GNMA 30 year mortgage loans which account for another
About 53.5% of its assets are invested in securities having a
maturity of 25 years and above, however, the weighted average
maturity of all the securities in the fund is only 2.56 years. This
enables the fund to face little in terms of interest rate risk,
especially when compared with other long-term focused peers (read
UBS Launches Monthly Leveraged Real Estate
Securities ETN (RWXL)
Although the Index is comprised of 998 securities, the fund
holds only 303 securities out of those. This implies that the ETF
does not follow a full replication strategy but a relative sampling
strategy which looks to follow the overall performance of the
Unfortunately investors have to pay 31 basis points in fees and
expenses for this service; however, the fund pays out pays out a
good yield of 3.56% per annum with monthly distributions. The ETF
has returned 5.88% in the past one year compared to the index
SPDR Barclays Capital Mortgage Backed Bond ETF (
This tracks the price and yield performance of the same index as
the previous fund i.e. Barclays Capital U.S MBS index, the only
difference being the number of holdings. MBS holds only 28
securities presently which best track the index.
Just like the previous ETF, it employs a representative sampling
technique rather than a full replication technique. The fund was
launched in January 2009 and since then the fund has managed to
garner about $33 million in AUM.
The fund normally focuses on securities having higher coupons
with a short term focus and assigns more weights to those
securities leading to high current income. The fund has a gross
expense ratio of 0.32%, thanks to the unique fund management
technique (see more on ETFs at the
However, the fund is yet to gain in popularity as suggested by
the inflows in its asset base and the average daily volume which
stands at 5,036, probably because investors perceive that such a
small sample size would not actually reflect the performance of the
index in totality resulting in higher index sampling risk.
Vanguard Mortgage-Backed Securities ETF (
VMBS was launched in November 2009, and tracks the performance
of the Barclays Capital U.S. MBS Float Adjusted Index. Like the
above two funds, this ETF employs a representative sampling
passively managed technique holding 342 securities out of the 998
securities held by the index.
The fund focuses on securities with shorter maturities and lower
modified duration in order to reduce interest rate risk. The
average modified duration of the fund is 2.8 years and the average
maturity is 4.7 years.
In less than three years since its inception, the fund has seen
a massive inflow in its asset base managing $165.2 million with
average daily volume at 28,995. The main reason for the popularity
of this product is its low-cost structure backed by its efficient
fund management techniques.
This mortgage-backed ETF charges investors a paltry 15 basis
points in fees and expenses and pays out 2.11% per annum as a
yield. The ETF has returned 6.17% in the past one year, making it a
solid performer in the competitive space.
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