When it comes to bond investing, having a strong core is everything. Investment-grade bonds often do the heavy lifting in a portfolio, providing income and stability. With low default rates and strong yields, these bonds create the resilience needed to help a broader stock portfolio fight volatility.
However, not all core bonds are the same. Some may provide substantial benefits to a portfolio and may be overshadowed by other investment-grade issues.
In this case, we’re talking about mortgage-backed securities (MBS). Both residential and commercial MBS can offer high yields, low volatility, and stability to a broader core bond portfolio. MBS makes a ton of sense for investors looking to enhance their income potential.
A Quick MBS Rundown
The Bloomberg Aggregate Bond Index is the standard bearer regarding so-called core bonds. These bonds are made up of the taxable investment-grade bond universe. The bulk of these bonds are issued by the U.S. Treasury. The rest, and the only two ways to diversify based on credit risk, are corporate bonds and a funky bond type dubbed MBS.
MBS is a pool of mortgages tied to homes or commercial properties. When you buy a house or commercial property, you talk directly to a bank or other lender that underwrites the loan. However, what happens next in the process is what creates the MBS.
Sometimes, it’s the bank/lender, or sometimes, it’s the government trio of Freddie Mac, Fannie Mae, and Ginnie Mae, but these organizations combine thousands of mortgages through securitization into MBS. These bonds are then sold to investors. The underlying properties are collateral, and interest and principal payments are passed through to MBS investors as coupon payments.
Why MBS are a Great Deal for Portfolios
In a core bond allocation, MBS bonds have some unique attributes that help power overall returns and reduce volatility. Those benefits are enhanced when focusing on the bonds themselves.
For starters, MBS often have higher yields than Treasury bonds. This is due to two factors. The obvious is that a homeowner isn’t the U.S. government. There’s greater credit risk when owning an MBS versus a Treasury bond. While foreclosures can happen and homes are sold to try to make a mortgage whole, sometimes there are still losses. This potential creates additional credit risk versus a Treasury bond.
Additionally, the opposite is true. Prepayment risk is real when it comes to MBS bonds. If mortgage rates drop, homeowners can refinance to lock in a lower rate. As a result, MBS may not fully realize the price appreciation from declining interest rates compared to other bond types. Due to this negative convexity, MBS bondholders demand a little more yield to compensate. Looking at the Bloomberg US Mortgage-Backed Securities Index over the last years, MBS provided a 55-basis-point yield advantage over a 10-year Treasury bond. Right now, the advantage is at 47 basis points. 1
But investors aren’t taking on much more real risk to get that yield advantage. That’s because agency MBS/CMBS features some unique risk attributes. Freddie Mac and Fannie Mae are government-sponsored enterprises, while Ginnie Mae is government-backed. These agencies provide a layer of safety for the MBS, and in the case of Ginnie Mae, 100% backing. This provides less credit risk than other investment-grade bonds outside of Treasuries.
As a result, MBS bonds have had some of the most attractive Sharpe Ratios of any core bond type. This chart from Janus Henderson shows the higher risk/reward ratio for agency MBS bonds.
Source: Janus Henderson
The higher yield and low credit risk have allowed them to outperform Treasury bonds over the long run. Moreover, MBS still managed to perform well during periods of strife. Looking at the Great Recession and Global Financial Crisis, the Bloomberg U.S. MBS Index produced annual returns of 6.9%, 8.4%, and 5.9% for 2007, 2008, and 2009, respectively.
Overweighing MBS Bonds
With positives over other varieties of investment-grade and core bonds, investors may want to consider MBS for their portfolios and include them as part of their core holdings. Luckily, this is pretty easy on a number of fronts.
There’s about $9.9 trillion worth of agency MBS bonds on the market or about 27% of the Bloomberg Agg index outstanding. Liquidity for the bond type is pretty robust. The issue comes down to being able to analyze the thousands of properties within the bonds to see if it’s worth your time and investment. That’s a job best left to the pros. Or, at a bare minimum, an index ETF.
Here again, there are plenty of choices.
Mortgage-backed Securities (MBS) ETFs
These funds are selected based on their ability to tap into MBS at a low cost. They are sorted by their 1-year total return, which ranges from 3.2% to 5.4%. Their expense ratio ranges from 0.04% to 0.66% and yields between 3.23% and 4.31%. Their AUM is between $290M and $26B.
Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
---|---|---|---|---|---|---|---|
LMBS | First Trust Low Duration Opportunities ETF | $4B | 5.4% | 3.82% | 0.66% | ETF | Yes |
JMBS | Janus Henderson Mortgage-Backed Securities ETF | $1.9B | 4.6% | 4.31% | 0.28% | ETF | Yes |
GNMA | iShares GNMA Bond ETF | $290M | 4.5% | 3.39% | 0.11% | ETF | No |
MBB | iShares MBS ETF | $25.9B | 4% | 3.38% | 0.05% | ETF | No |
VMBS | Vanguard Mortgage-Backed Securities ETF | $17.4B | 3.5% | 3.25% | 0.04% | ETF | No |
SPMB | SPDR Portfolio Mortgage Backed Bond ETF | $4.3B | 3.2% | 3.23% | 0.05% | ETF | No |
Active management exists in MBS as well. The potential for additional alpha comes not just from comparing similar agency bonds but from including non-agency bonds to enhance yield. This approach changes the risk/reward profile, and investors may see different results compared to broad indexing or holding only agency bonds.
Nonetheless, MBS can yield high returns than other investment-grade bonds, making them a smart choice for portfolio allocation.
Bottom Line
Not all core bonds are equal; some offer better returns and yields. MBS is one such asset class. These pass-through securities offer investors additional gains, lower volatility, and reduced risks compared to other bonds. Increasing MBS exposure in a portfolio could be a wise strategy.
1 Janus (September 2024). Agency Mortgage-Backed Securities