What Fed Action Means For Mortgage-Backed ETFs

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The Federal Reserve's plan to buy $40 billion a month in agency mortgage-back securities until job growth rises adds upward pressure to mortgage-backed securities. The question is how much?

If the Fed has guaranteed demand for home loans through MBS, or financial products with exposure to cash flows from mortgage loans, should you be buying them too? The Fed hopes to push down mortgage rates and boost home prices to prompt people to buy homes and spend the equity on consumer goods.

For some market strategists, Fed Chairman Ben Bernanke's plan, announced last week, invokes the old adage: You can't fight the Fed.

ETFs tracking MBS reacted positively Thursday after Bernanke dropped the QE3 bomb to keep interest rates at rock-bottom through 2015.

IShares Barclays MBS Bond ( MBB ) -- the largest ETF of its kind with $5.68 billion in assets -- rose 0.46%. It marked the largest one-day price gain in 13 months. It currently yields 3.17%. It holds primarily 30-year fixed, highly-rated, securities issued by three government enterprises: Government National Mortgage Association (GNMA or Ginnie Mae), Federal National Mortgage (FNMA or Fannie Mae), and Federal Home Loan Mortgage Corp. (Freddie Mac). The ETF settled back a bit on Friday and Monday.

Vanguard Mortgage-Backed Sector Index ETF ( VMBS ), yielding 1.14%, andSPDR Barclays Cap Mortgage Backed Bond ( MBG ), yielding 1.3%, also jumped Thursday.

"They will see further price increases, and yield declines, each month that the Fed buys $40 billion worth," said John Graves, editor of "The Retirement Journal." "The Fed has guaranteed a market for these securities, as they have for $2 trillion in U.S. bonds."

Bond king Bill Gross already had put half of his $272.5 billion Pimco Total Return -- the world's largest bond fund -- in MBS. The founder and co-chief investment officer at Newport Beach, Calif.-based Pimco told Dow Jones he knew the high unemployment rate and slow recovery would make the Fed provide more stimulus. He believes the Fed's easy money policy could last for years.

Marginal Impact

But some market strategists doubt MBS ETFs have much upside potential and say the Fed's impact will be marginal.

"The mortgage-related portion of the U.S Investment Grade Bond Index is just over $8.0 trillion," said Wayne Schmidt, chief investment officer at Gradient Investments in Shoreview, Minn. "The Fed program is targeting 0.5% of the total pool of agency mortgage-backed securities. If the program continued for one year, their purchases would equate to about 6% of the total market."

Mortgage rates are already at 30-year historic lows. If they fell further, they would be a less attractive investment than government bonds, which carry considerably less risk with comparable yields.

The average 30-year fixed-rate mortgage hovers near 3.52% and the average 15-year yields 2.93%, according to Bankrate.com. Theoretically that's the most yield investors can earn on them. By comparison, 30-year Treasury bonds yielded 3.09% as of Friday. Twenty-year bonds yielded 2.68%.

"Investors still would need some risk premium on MBS, given the nature of the security," said Matt Reiner, portfolio manager at Wela Strategies in Atlanta.

MBS are subject to prepayment risk that could lead to losses. If interest rates fall, homeowners are likely to refinance to reduce rates.

"The loss comes about because investors only receive par when mortgage holders refinance their mortgages," explains Keith Newcomb, portfolio manager at Full Life Financial in Nashville. "For instance, 4.5% (yielding) MBS are trading around 108, and when a mortgage inside is refinanced, the owner of the MBS only receives 100. If the owner paid a premium, that prepayment results in a capital loss, and forces the investor to reinvest at the currently lower prevailing yield."

But banks have been very uptight about lending and there may be fewer refis and prepayments than expected, Newcomb said.

If interest rates rise, MBS prices will fall. But that's unlikely. "Since the Fed will keep the interest rate low through 2015, the risk of buying these MBS bonds now is the refinancing risk and the leverage," said Tahar Mjigal, director of risk management at International Capital Management in Dallas. "This could trigger a wave of refinancing."

Unfortunately, homeowners can't refinance to take advantage of lower rates if their homes are underwater. As of the second quarter, about 22.3% of properties are worth less than what their owners paid for them, according to CoreLogic. This amounts to 10.8 million homeowners. Another 2.3 million have less than 5% equity in their homes, which is considered near negative equity.

There's no guarantee the Fed's plan will do what it intends. QE3 opponents note the Fed already tried to jump-start the economy via QE1 and QE2, which failed by most estimates.

"Loose monetary policy created the housing and stock bubbles of the last decade, the bursting of which almost blew up the economy," wrote Peter Schiff, CEO of Euro Pacific Capital.

"As someone who bought his first house with a 13% interest-rate mortgage, I have trouble accepting the idea that 3.25% for 30 years is so high that it is making people hold back," Tom McClellan, editor of the McClellan Market Report, wrote. "It's probably something else that is giving consumers pause."

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs
Referenced Symbols: MBB , MBG , VMBS

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