The Cheapest Mortgage Fund Available

This article is now exclusive for PRO subscribers.

By Thomas Boccellari

Vanguard Mortgage-Backed Securities ETF (NASDAQ:VMBS) provides exposure to mortgage-backed securities issued by U.S. mortgages agencies, such as Ginnie Mae, Freddie Mac, and Fannie Mae. As of October 2014, Agency MBS represented 20.7% of the Barclays U.S. Aggregate Bond Index. Because of their large representation within the benchmark, MBS may be used as a tactical investment when investors think mortgages are cheap relative to Treasuries and corporate bonds.

While mortgage-backed securities issued by Fannie Mae and Freddie Mac are not explicitly guaranteed by the U.S. government, investors commonly assume that there is an implicit guarantee that the government will back the bonds’ interest and principal payments. These agencies are private companies created by the government with a public mission: to make mortgage financing more affordable. During the 2008 financial crisis, the U.S. Federal government made substantial investments in Fannie Mae and Freddie Mac to improve their liquidity and allow them to support their liabilities and mortgage-backed securities in exchange for preferred shares. This ownership stake, coupled with the agencies’ public mission and importance to the refinancing market, suggests that the government may provide support if mortgage troubles arise again.

Mortgage-backed securities are constructed by pooling together a variety of different individual mortgages into one security. This starts with a lender, such as a bank, making an individual mortgage loan. But if the lender does not want to hold the loan on its balance sheet for its full term, it may sell the mortgage to an agency, such as Fannie Mae or Freddie Mac, to monetize the asset. The agency will combine a variety of different mortgages to create the mortgage-backed security, which offer investors diversification and liquidity. The mortgage-backed security issuer passes along interest and principal payments from the underlying pool of assets to investors.

Mortgage-backed securities generally pay greater interest than similar maturity Treasuries, but less than similar maturity corporate bonds. However, unlike these bonds, borrowers can prepay mortgages. This is a particularly big risk in a falling-interest-rate environment when borrowers refinance their mortgages. When this occurs, investors get their principal back before maturity and have to reinvest at lower interest rates. Conversely, in a rising-interest-rate environment, mortgages have extension risk--or the risk of capital being invested at low rates for an extended period of times where rates are likely to increase, providing a lower yield than the market.

Because mortgages can be refinanced, they have call risk--the risk that borrowers refinance their mortgages. This can become troublesome because the investor will get the investment principal back before its maturity and have to reinvest the capital at a lower interest rate. While years of falling and low interest rates led to increased refinancing of existing mortgages, refinancing activity has slowed considerably over the past two years. The current Mortgage Bankers Association Refinance Applications Index shows that the current refinancing rate is back to its 10-year trailing average. Even if interest rates remain low for the foreseeable future, refinance risk is less than it has been over the past five years because most people who can refinance their mortgages to lower rates already have.

At the end of October 2014, the 30-year mortgage rate (4.0%) was up 0.7% from its December 2012 low (3.3%). The spread between the 10-year Treasury benchmark yield and the 30-year mortgage rate increased from a low of 1.5% in January 2013 to 1.7% in October 2014. The current spread is in line with the trailing 20-year average through October 2014.

According the fourth quarter Morningstar Markets Observer, the average borrower’s FICO score--a measure of a borrower’s credit-worthiness--for approved mortgages has been declining since 2009, when credit standards were tightened because of an increase in mortgage defaults. The average FICO score (744) at the end of September 2014 was lower than the average at the end of December 2013 (753). The current FICO scores are still significantly above pre-market-crisis levels (715). Investors can benefit from this because the yields on these mortgages will be higher. While this might increase risk, mortgage agencies purchase only prime mortgages.

While mortgages rates have climbed a little, the easing of credit standards has increased the number of mortgage applications. According to a November 2014 MBA report, new mortgage applications increased 4.9%. Further, new housing starts and new permits have both increased. According to an October 2014 report by the U.S. Commerce Department, housing starts and new permits increased 6.5% and 1.5%, respectively. The new permits indicator is important because it shows future construction and implies that mortgage applications will likely rise in the future as the future projects come to fruition.

The fund’s index’s yield to maturity (2.7%) is below the 10-year trailing average (4.0%) through October 2014. This is primarily a function of interest rates generally falling over this period. However, the current yield is in line with the average yield over the trailing three years through October 2014, when interest rates remained relatively low.

Portfolio Construction
The fund employs representative sampling to track the Barclays U.S. MBS Float Adjusted Index, which measures the U.S. agency mortgage back securities market. The securities are issued by Ginnie Mae, which is explicitly backed by the full faith of the U.S. Federal Government, and Fannie Mae and Freddie Mac. The securities include 15-, 20-, and 30-year mortgages, as well as balloon payment mortgages. The securities must have a remaining maturity greater than one year and have at least $250 million in par value outstanding. Unlike its sister index, the Barclays U.S. MBS Index, the Barclays U.S. MBS Float Adjusted Index excludes mortgages held by the Federal Reserve from its weighting calculations. The index weights its holdings by market capitalization and rebalances at the end of each month.

The fund has an expense ratio of 0.12%, which makes it the cheapest mortgage focused fund available. Over the trailing three years through October 2014, the fund has trailed its bogy by 0.10% annualized.

iShares MBS (NYSEARCA:MBB) (0.27% expense ratio) is the largest mortgaged-focused ETF. While the index it tracks is nearly identical to that tracked by VMBS, MBB includes mortgage securities owned by the Federal Reserve. Despite this difference, the two fund’s indexes’ performance has been nearly identical. SPDR Barclays Mortgage Backed Bond ETF (NYSEARCA:MBG) (0.29% expense ratio) tracks the same index as MBB but has significantly fewer assets. This can make it more expensive to trade.

Investors looking for greater diversification might consider aggregate bond funds. Schwab U.S. Aggregate Bond ETF (NYSEARCA:SCHZ) (0.06%) is the lowest-cost bond fund. In addition to agency mortgage-backed securities, it invests in corporate bonds and Treasuries. As of this writing, 30% of its assets were invested in mortgage-backed securities.

Vanguard also offers this fund as a mutual fund, Vanguard Mortgage-Backed Securities Index Admiral (MUTF:VMBSX), with the same expense ratio. It has a $10,000 minimum investment.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.