Want steady income and safety? Think MBS ETFs

September 27, 2011

Juliette Fairley is a frequent commentator on Better Home and Garden TV. She has written for the Wall Street Journal, the New York Times and USA Today. The opinions expressed are her own.

Global markets have been slumping since Standard & Poor’s downgraded the U.S. AAA credit rating on Aug. 3, 2011 but niche funds that specialize in mortgage-backed bonds are maintaining gains.

Those funds are mortgage-backed securities exchange-traded funds (MBS ETFs), which invest in highly liquid Fannie Mae and Freddie Mac loans that consist of pools of individual residential mortgages. When homeowners pay their mortgage, the interest is received by the bond holder.  The size of the MBS ETF market is $3.5 billion as of Sept. 21, 2011 with the majority of assets falling under iShares Barclays MBS ETF, according to Morningstar.

“Investors prefer mortgage backed securities due to the fact that the U.S. government stands fully behind them which still give them a high degree of safety considering the recent S&P downgrade,” says Maurice Wilson, a financial adviser with Wilson Wealth Management Group in Charlotte, North Carolina.

When the U.S. had a AAA credit rating, MBS ETFs were a relatively risk-free investment. But even with the S&P downgrade of the United States from AAA to AA, investors are still flocking into Treasury-related debt, driving up the prices on MBS. “Mortgage backed ETF’s act like a Treasury bond so for an investor considering their portfolio’s bond allocation, their purpose is steady income,” says Morningstar ETF analyst Timothy Strauts.

Indeed, the big lure is juicy returns. The average one year annualized return for the category was 5.7 percent as of Sept. 20, 2011, according to Morningstar. “An MBS ETF can be positioned as a piece of a client’s income pie,” says John F. Harrison, a certified financial planner with Aspire Financial Advisors in Newton, Massachusetts.

Another reason Harrison and other advisers like MBS ETFs is because they are perceived to be safer than mutual funds that invest in private-label MBS, such as 40-year mortgages and jumbo loans. The mortgages that make up the securities in these mutual funds do not have the backing of the government and as a result carry a significantly greater risk.

Wilson invests 80 percent of his client’s portfolios in ETFs, about 25 percent in MBS ETFs, and the other 20 percent in blue chip stocks, such as McDonald’s, Coke, T. Rowe Price and Apple.  The remaining 35 percent is invested in a mix of leveraged ETFs and broad-based U.S. and non-U.S. market cap ETFs.

Wilson advises investors to look at the portfolio holdings of MBS ETFs carefully because there might be overlap with other bond ETFs or bond index funds they may already own. For example, Vanguard’s Total Bond Market ETF carries nearly 30 percent of government mortgage-backed securities as well as corporate and treasury bonds.

The top performing MBS ETFs in the past six months through Sept. 20, include Vanguard Mortgage-Backed Securities Index ETF up 4.3 percent, SPDR Barclays Capital Mortgage Backed Bond up 4.5 percent percent and iShares Barclays MBS Bond up 4.4 percent, according to Morningstar.

The biggest MBS ETF is iShares Barclays with $3.4 billion. All three ETFs are benchmarked to the BarCap US MBS Index whose 3-year annualized return was 6.8 percent compared to the Barclays Aggregate Bond Index, which consists of corporate, Treasury and MBS bonds.

Keep in mind that investors are exposed to default risk when homeowners do not pay their mortgage but because mortgage backed securities are invested in Fannie Mae and Freddie Mac loans, which are guaranteed by the government, MBS ETFs do not carry default risk. Thus, MBS ETFs are considered secure investments because the holding’s interest and principal is backed by the U.S. government if homeowners default.

Although defaulting homeowners is not a risk of investing in MBS ETFs, prepayment risk is still significant. “Prepayment risk comes from the fact that if interest rates go down, people may refinance their mortgages and pay off their loans sooner, which shortens investors’ anticipated income stream and returns principal that must be reinvested at lower rates,” Harrison says.

The operating cost or expense ratio is what distinguishes one MBS ETF from another. “The operating cost of a particular fund is expressed as a percentage of the pool of assets. A lower expense ratio allows you to take home more of the fund’s gains because expenses are less of drain on those gains,” says Wilson.

Neither SPDR Barclays MBS ETF nor Vanguard mortgage-backed ETF, for example, have manager skills to pay for and both are index funds.  As of September 20, 2011 Barclay’s ETF produced an annualized one year return of 5.8 percent with a 6.14 percent return since inception Jan. 15, 2009 and has a 0.32 percent gross expense ratio compared to the expense ratio for Vanguard’s ETF at 0.15 percent and iShares MBS ETF at 0.31.

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