New iShares MBS Fixed Rate Bond ETF Not As Risky As It Seems

Barclays Global Investors [BGI] continued the expansion of its fixed-income exchange-traded fund line-up last week, launching the new iShares Lehman MBS Fixed Rate Bond ETF (MBB) onto the New York Stock Exchange [NYSE] on March 16. The new fund provides exposure to the suddenly controversial “mortgage-backed securities” [MBS] market, and comes amid a flurry of news coverage about rising delinquencies among sub-prime loans. Many have questioned the timing of the launch as a result, wondering if the only demand for the ETF will come from the short side of the spectrum.

A closer look suggests investors shouldn't be so concerned with the fund's risk. The new ETF invests only in mortgages from the three government-sponsored and/or chartered mortgage giants: Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae. Broadly speaking, those mortgages carry little risk. Ginnie Mae mortgages, for instance, are backed by the full faith and credit of the U.S. government, giving them risk profiles equivalent to Treasuries.

The situation with Fannie Mae and Freddie Mac is different. The two companies are chartered by the U.S. government, and many believe the government will not let the companies default; they are, in essence, too big to fail. But the government is under no obligation to bail out these companies, and that means some level of risk remains. Still, buyers of Fannie and Freddie mortgages stand a very good chance of receiving their payments. Both companies guarantee payments with the full weight of the corporation; investors aren’t exposed to individual mortgages or packages of mortgages. As a result, the companies would have to fail entirely for the bonds to be at risk. That is possible, of course, but highly unlikely

The truth is that many bond investors already have substantial exposure to these very same securities, and they don't worry about that too much. These same securities make up the largest single tranche of the Lehman Aggregate Index, the benchmark for the $5.6 billion iShares Lehman Aggregate Bond Fund (AGG), the largest bond ETF on the market. Together, the MBS' represent 35 percent of the AGG. If you're worried about the new fund, you should be worried about AGG, too.

Investors concerned about the mortgage market may well use this fund to hedge out exposure from a broader AGG position. But the historical volatility of the index is very small, and the truth is that the underlying securities are not as risky as many believe; these are not, by and large, the sub-prime mortgages that have caused so much consternation on the market.

The biggest fault of the new fund is its expense ratio, which, at 25 basis points, is the highest for any bond ETF currently on the market.

The prospectus is available here.