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One day, there may be a significant amount of public anger regarding mortgage-backed securities (MBSs). This will occur after mortgage interest rates have risen. This will occur when it becomes clear to many individuals invested in MBSs that they offer a raw deal. The deal is that you benefit a limited amount when mortgage interest rates fall. You suffer a heightened amount when mortgage interest rates rise.

The Deal

Basically, it works this way. When mortgage interest rates are falling, people refinance their mortgages more often; and they are encouraged to move because they will likely get a lower interest rate if they do. When they refinance or move, they pay off their mortgage in your MBS early. The amount which the principal value of your MBS rises in response to mortgage interest rates falling is limited due to more people than anticipated refinancing or moving. More specifically, in part, instead of a rise in principal value, you get your principal back sooner; but, if you reinvest it in another MBS, as an MBS fund needs to do, you have to do so at a lower interest rate. Now you are making a smaller percentage in interest, but you did not get a matching benefit in principal gain. If you hold the original MBS to maturity, you end up with less higher-interest-paying principal to hold to maturity. The phenomenon described in this paragraph is known as prepayment risk.

When mortgage interest rates are rising, people refinance their mortgages less often, if anyone refinances at all; and they are discouraged from moving because they will likely have a higher interest rate if they do. This means they are much more likely to maintain their mortgage for the entire 30 or 15 year period. By far, most U.S. mortgages are for 30 years. In regard to your MBS, you get your principal back later; so there is less principal available to reinvest at the higher mortgage interest rates. The fall in the principal value of your MBS is larger than the rise in principal value was when interest rates fell. If you hold the original MBS to maturity, you end up with more lower-interest-paying principal to hold to maturity. The phenomenon described in this paragraph is known as extension risk.

To summarize, when you win, you win little; when you lose, you lose big. You should be receiving a much higher True Yield for MBSs to make up for this, but you are not. (For an explanation of True Yield, please see my article entitled "The True Yield of Your Bond Investments".)

Yields

To my knowledge, there are five MBS ETFs.

  • iShares Barclays MBS Bond Fund (NYSEARCA:MBB)
  • Vanguard Mortgage-Backed Securities (NASDAQ:VMBS)
  • iShares Barclays CMBS Bond Fund (NYSEARCA:CMBS)
  • SPDR Barclays Capital Mortgage-Backed Bond (NYSEARCA:MBG)
  • iShares Barclays GNMA Bond Fund (NASDAQ:GNMA)

MBB tracks the Barclays U.S. (Investment-Grade Agency) MBS Index. MBG tracks the same index. VMBS Tracks a float-adjusted version of the same index. This float-adjusted version treats MBS positions held by the U.S. Federal Reserve as if they are not part of the marketplace. GNMA tracks the GNMA sub-index of the same index MBB and MBG track. CMBS holds commercial, versus residential, MBSs.

Per the State Street Global Advisors SPDR website for MBG, the index tracked by MBB and MBG had a yield to maturity (YTM) and yield to worst (YTW) of 2.10% as of 10/19/12. Subtracting MBB's 0.26% expense ratio gives you a theoretical 1.84% yield for MBB. Subtracting MBG's 0.32% expense ratio gives you a theoretical 1.78% yield for MBB. Per the Vanguard website for VMBS, the index tracked by VMBS had a YTM of 1.7% as of 9/30/12. Subtracting VMBS's 0.15% expense ratio gives you a theoretical 1.55% yield for VMBS. GNMA's yield should be about in line with the above yields. CMBS's yield is about in line, based upon an analysis of the fund's holdings as displayed on the BlackRock iShares CMBS Holdings webpage.

Maturities

Although there are currently years-to-maturity figures of about four years listed for the Barclays U.S. MBS Indexes on the SPDR and Vanguard websites, MBS ETFs are not short-term funds. (CMBS may, even, effectively be long-term.) The four years seems to anticipate a level of refinancing similar to the current one. Once mortgage interest rates stabilize or begin to move up, the higher level of refinancing will end; and the years-to-maturity figures for the MBS indexes should be much larger. The 30-year mortgage interest rate that was 3.37% on 10/19/12 was 6.24% on 11/16/07, before the recession started. The 15-year mortgage interest rate that was 2.66% on 10/19/12 was 5.88% on 11/16/07.

I used the data available via the iShares MBB Holdings webpage to determine that, as of 10/18/12, the weighted average maturity of the MBSs in MBB was 19.75 years. (The weighted average maturity of the MBSs in CMBS was 31.24 years when determined this way.) This figure differs from the four year figure because it does not account for people paying off their mortgages early. People pay down their mortgages over time; so, when someone gets a 30-year mortgage, they are not borrowing the full amount for 30 years. Since, in the earlier years of a loan, the borrower pays relatively more interest and less principal, the average length of borrowing on a standard 30-year loan is some number significantly greater than 15 years. By the same logic, the average length of borrowing in relation to MBB seems to be some number significantly greater than 9.88 years. MBS ETFs are, on average, intermediate-term funds.

Conclusion

With an MBS or MBSs fund, you get a yield that is significantly less than that which you get in a well-chosen all/intermediate-term fixed-income investment; and you get the "raw deal" related to mortgage interest rate movements I described earlier in this article. (For help in finding well-chosen all/intermediate-term fixed-income investments, please see my previous articles entitled "The Best All/Intermediate-Term Non-Junk Bond Investments" and "The Best Intermediate-Term Non-Junk Individual Bond Investments".) With interest rates in general much more likely to rise than fall in the intermediate/long-term, the situation regarding MBSs with a longer time-to-maturity, and MBSs funds to be held for more than a short while, is even less attractive than it would be otherwise. Couple this with the fact that the MBSs market is temporarily being artificially supported by the U.S. Federal Reserve, and, if you are currently holding an MBS with a longer time-to-maturity or an MBSs fund, you really do not want to hold for much longer.

If you own an aggregate bond market ETF like Vanguard Total Bond Market (NYSEARCA:BND), iShares Core Total US Bond Market (NYSEARCA:AGG), or PIMCO Total Return (NYSEARCA:BOND), a large portion of the ETF may be MBSs. Per Morningstar, BND has 28.09% in MBSs, AGG has 28.10% in MBSs, and BOND has 24.23% in MBSs. BND and AGG also hold a lot of artificially-supported-by-the-Federal-Reserve and otherwise-overbought U.S. Treasuries, making BND and AGG rather risky investments.

Disclosure: I manage a portfolio with an MBS mutual fund position which is in the process of being exited. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Mortgage-Backed Securities Offer A Raw Deal