MBB: A Sell Due To Widening Mortgage Spreads

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About: iShares MBS ETF (MBB), Includes: FMCC, FNMA, NLY, REM
by: Nairu Capital
Summary

The iShares MBS ETF has been one of the best-performing ETFs on a risk-adjusted basis over the past nine years.

Falling interest rates have pushed the fund up this year, but rising mortgage spreads threaten to push it back down.

Increasingly likely re-privatization of Fannie and Freddie may create poor risk-adjusted performance for the ETF over the coming year.

Using a quant model shown in the article, I forecast the fund to fall to $105 by year-end.

(Source: Pexels / David McBee)

On a risk-adjusted basis, low-risk, mortgage-backed securities have actually been one of the best investments since their 2007-2009 explosion. It's fitting - investors in the asset class were burned and have been cautious to re-enter the market.

Accordingly, the iShares MBS ETF (MBB) has maintained a CAGR of 3.6% per year, with the worst year resulting in a small 1.95% loss. This has given the fund an impressive running Sharpe (reward/risk) ratio of 1.1.

So far, 2019 has been one of the best years for the fund on record. As interest rates rose last year, the fund fell by about 4.5% (before dividends). All rates reversed to the downside and hit new all-time lows (possibly 5000-year lows). The average 30-year mortgage in the U.S. has fallen from 4.85% in January all the down way to 3.5%, and MBB has risen from $102 to over $108 today (6.3% before dividends).

In my opinion, now is the time to take profits and move to other alternatives for MBB. While the housing market is much stronger today than in the past, mortgage spreads from treasury rates are rising quickly and are likely to be a boon for the ETF. Even more, the re-privatization of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), which guarantee 72% of the fund's holdings, may cause a rapid rise in the risk premium on their MBS's and push prices down or create volatility.

If investors are still looking for yield and exposure to the mortgage market, they may have better luck in mortgage REITs such as the iShares Mortgage Real Estate Capped ETF (REM) or (my favorite) Annaly Capital Management (NLY) that are set to gain from the widening mortgage spread.

The iShares MBS ETF

MBB invests in the lowest-risk segment of the mortgage-backed security market, as all of its holdings are AAA rated and are guaranteed by either Fannie Mae (43%), Freddie Mac (29%), or the U.S. government (Ginnie Mae) (24%).

Holdings breakdown:

(Source: iShares)

The fund was incepted with perfect timing, March 2007, but only suffered a 3.2% loss in principal, as it was primarily invested in ultra-low risk government-sponsored mortgages. This can be gently compared to the 80% decline in mortgage REITs (REM) over the same period.

Although the fund has almost no coverage on Seeking Alpha, it is one of the most heavily invested ETFs with just under $19 billion in AUM, with the majority of owners being banks and pension funds. For example, Bank of America (BAC) itself owns roughly a third of all shares outstanding.

Let's take a look at that AUM over time to see what exactly those primarily institutional investors have been up to:

Chart Data by YCharts

As you can see, they have been utterly voracious in their appetite for MBB since January. In my opinion, when AUM rises this quickly on the back of no positive changes to fundamentals, something is clearly wrong. Perhaps this is yet another story wherein risks are grossly underestimated and ties back into the "rates only go down" narrative.

For what it's worth, the fund does have some attractive qualities. It pays a dividend yield of 2.7% and has an expense ratio of merely 7 basis points. MBB also has no correlation to the S&P 500 (unlike most low-risk bonds, which are negatively correlated). The average maturity is a low risk of 4.3 years and is distributed as follows:

(Source: iShares)

The fund is low-risk and does pay decent dividends for that low level of risk. That said, I believe the fund's rewards are likely to decline going forward.

Macro Pressures All Signal Higher Mortgage Rates

Inflationary fundamentals are rising, interest rates cannot fall much lower, and mortgage rate spreads are on the rise. Even more, the increasingly likely re-privatization of Fannie Mae and Freddie Mac will result in a higher risk premium on the 70% of the bonds in the ETF that is guaranteed by those two organizations. The effect may be limited, as I expect the U.S. government to be careful in this endeavor, but it does pose a risk for the fund.

The ETF's price depends directly on that of mortgage interest rates. To demonstrate, take a look at MBB's price versus the average 30-year mortgage rate and treasury rates:

(Data Source: Federal Reserve Economic Database / Yahoo Finance)

As you can see, the fund is negatively correlated to 30-year mortgages and treasury interest rates. To see this even more clearly, I've created a simple model for predicting the price of MBB.

If you are curious:

Expected MBB Price = 117.25/(1+47% * 30-year mortgage + 16% * 1-year treasury - 6% * 30-year treasury)^(4.75)

Shown below, you can see that MBB closely tracks the expected price of the model. I also added the implied current yield of MBB from the model and a fitted trend line:

(Data Source: Federal Reserve Economic Database / Yahoo Finance)

As you can see, MBB is once again trading above its expected price given the three interest rates. While MBB is only slightly above the expected level, it is a sign that investors may have pushed yields on low-risk mortgages too low.

Even more, we can see that the implied yield has broken down below its trend. This is a speculative point, but the concave uptrend in the yield that was in play from 2007 to January of this year was very strong. The current yield is far below that trend, which is a sign that mortgage-backed security bonds (and perhaps all bonds) in general are the most overbought since 2007.

This may be fading soon, and investors may be in for a surprise, as the mortgage-to-treasury spread is widening very quickly, which is a sign that cracks are beginning to form in the mortgage market. We can see this through the 30-year mortgage rate minus the 30-year treasury rate:

(Data Source: Federal Reserve Economic Database)

This spread has been on a clear uptrend since bottoming out in 2010 after the dust settled in the mortgage market. The widening spread is a sign that investors are demanding a higher risk premium on mortgages and that demand for mortgages is growing (perhaps for less-qualified borrowers). Nevertheless, this widening spread will be a boon for the principal value of MBB.

Of course, all of these higher rate expectations do mean higher dividend payments in the future. That said, as I'll demonstrate in the next section, it likely means lower returns and possible negative performance until then.

Quant Price Forecast and the Bottom Line

Fortunately, forecasting bond prices is a much more straightforward process than forecasting equities, as bonds move very structurally. Unfortunately, doing so still has limited accuracy, as the future is non-deterministic, and should be taken with a grain of salt.

Still, we know that MBB is trading at a premium to our expected price and that yields are lower than reasonable. Using these assumptions, one can create a forecast of the future yield of the bonds and their price. Here is my forecast for MBB, assuming prices and yields converge to expected value:

(Data Source: Federal Reserve Economic Database / Yahoo Finance / Self-Sourced)

Although I am willing to bet on this forecast, many variables could prove it wrong. These include (but are certainly not limited to) future Fed interest rate change shocks, surprises regarding re-privatization of Fannie and Freddie, and a large drop in inflation. In my opinion, shocks the Fed rate changes are likely to be the upside, re-privatization is more likely to be a boon on mortgage-backed securities, and inflation may also surprise to the upside. Still, these are important risks to keep an eye on.

I own long-term slightly out-of-the-money puts on MBB. Directly shorting the fund is likely a fruitless endeavor because the fund is not volatile enough and I want to take advantage of rising volatility. It is worth noting that higher yields will result in higher dividend payments, so the downside is mitigated over the long run. In the short run, declines in principal seem very likely. I give MBB a "Sell" rating, but will change that view after interest rates rise.

Disclosure: I am/we are short MBB. 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.