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SEC Scrutinizes ETF Industry, Mulls New Rules

Among the fixed income exchange traded funds benefiting from the Federal Reserve’s lower for long policy are ETFs holding mortgage-backed securities, or MBS.

For instance, ETF investors have a number of options to choose from, including the iShares MBS ETF (MBB) , Vanguard Mortgage-Backed Securities Index ETF (VMBS) , SPDR Barclays Mortgage Backed Bond ETF (MBG) , iShares CMBS ETF (CMBS) , iShares Core GNMA Bond ETF (GNMA) , FlexShares Disciplined Duration MBS Index Fund (MBSD) and First Trust Low Duration Mortgage Opportunities ETF (LMBS) .

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To start off, 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 a “pass-through” security where the principal and interest payments are passed through the issuer to the investor.

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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.

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“MBS are fairly valued but offer the potential for additional yield relative to duration when compared with other high-quality options. In a low-return environment, extra yield is hard to come by, and may have a larger relative impact on portfolio performance than it has in recent years. These factors, along with our belief that MBS may outperform comparable Treasuries if rates stay range bound or rise slightly, make MBS an attractive consideration for suitable investors looking to add high-quality bond exposure to their portfolios,” according to a note from LPL Financial posted by Amey Stone of Barron’s.

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.

iShares MBS ETF


The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.