What are Mortgage-Backed Securities ETFs?

Key Takeaways

• Pools of mortgages offered to investors as a single investment are referred to as mortgage backed securities.

• Exchange traded funds combine the simplicity of trading securities with the diversification of mutual funds.

• A mortgage-backed security exchange traded fund is an ETF that focuses on mortgage-backed securities.

Potentially useful for fixed income investors seeking possibly higher yields than might be achievable with U.S. treasuries, mortgage-backed securities exchange traded funds (MBS ETFs) can be beneficial when interest rates are low. These asset-backed securities tend to proliferate during periods when interest rates are in decline, because the demand for mortgage loan often accelerates. This can present the possibility of an opportunity for investors to profit from MBS ETFs.

What is a Mortgage Backed Security?

A mortgage-backed security (MBS) consists of a pool of mortgages offered to investors as a single investment vehicle. Consider a scenario in which a mortgage lending company writes 100 Fannie Mae mortgages over the course of a four-week period. Those loans could be subsequently bundled into a single package and sold off to investors. Doing so realizes an immediate profit for the mortgage lender, while affording investors an opportunity to realize ongoing gains as the interest on those loans is paid.

MBS Benefits

The primary MBS benefit for the investor is the potential for steady income the backing loans could generate. Because the payments on the mortgages are passed directly to the investors, potential returns could be periodic as well as predictable. Moreover, because that MBS package contains a multiplicity of loans, the odds of the occurrence of a catastrophic default are greatly reduced.

Said differently, MBS investors do not have to rely on a single borrower to secure a return. The inherent diversification of the MBS spreads an investor’s risk across many loans—rather than concentrating it into one. Thus, a $100,000 MBS investment has a far greater likelihood of generating returns than lending a single borrower $100,000 to purchase a property. In this way, the MBS serves to minimize risk for the originating lender as well as the eventual investor.

What is an Exchange Traded Fund?

An exchange-traded fund (ETF) combines the simplicity of trading securities with the diversification of mutual funds. Perhaps the easiest way to think of an ETF is as an opportunity to invest in many securities all at once. Even better, ETFs provide this diversification potential while imposing lower fees than would be incurred when spreading a capital investment across a number of individual securities. Trading ETFs is also simpler to do. Offered in a broad variety of types, the ETF’s closest corollaries are mutual funds and index funds.

Types of ETFs 

The types of investments they contain are used to categorize ETFs. 

• Stock-based ETFs are generally geared for long-term growth. Comprised of multiple assets within a specific aspect of the securities marketplace, stock-based ETFs tend to carry less risk than individual stock investments. However, they also carry more risk than, say, bond ETFs.
• Commodity-based ETFs bundle securities in goods such as gold, soybeans and natural gas. The key here is to determine whether the fund is comprised of shares of the fund’s physical stockpile, or equity in companies dealing in those materials. Either is okay, as long as the investor is aware of the nature of the investment. 
• Futures contracts also come into play with commodity ETFs. Another thing to consider is whether the IRS looks upon the commodity as a collectible. Such distinctions can have specific tax implications of which investors should be aware. 
• Bond ETFs tend to be good sources of income for investors. Bond funds, unlike individual bonds, lack maturity dates. Instead, the income derived from bond-based ETFs is generated by interest earned on the bonds comprising the fund. Bond ETFs are considered good portfolio complements to stock ETFs. Because they tend to carry less risk, bond ETFs offer the potential of good diversification opportunities. 
• Sector ETFs provide opportunities to invest in specific sectors of an economy, such as health care, finance, or tech. These can be useful tools for the investor who tracks business cycles. After all, certain sectors of the economy thrive during periods of expansion, while others prosper during contractions. However, it should be noted that sector ETFs tend to be riskier than the broad market ETFs discussed above. 

These are but four of the types of ETFs available to investors, another of which includes mortgage-backed securities exchange traded funds—or MBS ETFs.

What is a Mortgage-Backed Security Exchange Traded Fund?

At this point, the astute reader may have surmised a mortgage-backed security exchange traded fund is an ETF focused on mortgage-backed securities. In essence, MBS ETFs are bundles of bundles of mortgage-backed securities traded on exchanges in much the same fashion as individual stocks, bonds, and commodities.

The securities comprising a fund are rated for risk by the perceived strength of their credit ratings. Coupons, the yield of which is assigned based upon those ratings, are issued to investors. Interest payments associated with the coupons vary according to their associated ratings. Lower-rated securities carry higher coupon rates, while higher rated securities offer lower coupon rates. In other words, the more risk an investor is willing to assume, the higher the potential rate of return. 

MBS ETF Examples

Pass-Through MBS ETFs – MBS ETFs issued by government-sponsored entities such as Fannie Mae, Freddie Mac and Ginnie Mae are considered pass-throughs. This is because intermediaries pass the payments from the issuers through to the investors. 

A pass-through trust is taxed according to the associated grantor trust rules. These regulations require pass through certificate holders to be taxed as direct owners of the percentage of the trust apportioned to them by the certificate.

MBS ETFs trade on exchanges in much the same fashion as other types of ETFs. While they typically come with maturity dates, the average life span of a security can be shorter than the assigned date.

Collateralized Mortgage Obligations – These are made up of multiple pools, commonly referred to as “tranches”. Each of these pools is guided by a different set of maturities and priorities related to the issuance of principal and interest payments. 

Credit ratings are also assigned to the different tranches. Pools considered to comprise the least amount of risk offer lower interest rates. Conversely, the tranches deemed high risk pay higher interest rates.

MBS and the 2008 Financial Crisis

The term mortgage-backed securities may sound familiar to those who have been following the markets over the past 15 years or more. The events predicating the financial crisis of 2008 have been largely attributed to the fact that the MBS marketplace operated largely unregulated. 

As illustrated above, one of the key benefits of the MBS market is lenders get immediate returns on the mortgages they write when they sell a bundle containing those loans to investors. This attracted people who were willing to issue mortgages at interest rates that undercut those of traditional lenders in order to harvest quick returns. Additionally, they were not particularly choosy about the people to whom they granted loans. 

Forced to compete on this basis, established lenders were compelled to relax their lending standards. At the same time, there was a massive government-backed push to increase home ownership. As a result, many of the people who were granted mortgages would not have qualified for loans in a normal market. 

Predictably, a large number of those borrowers defaulted on their loans. This ruined many investors. It also triggered the failure of several major investment and commercial banks. Mortgage lenders, insurance companies and savings and loan associations suffered significant losses as well.

Resulting legislation included the Dodd-Frank Wall Street Reform and Consumer Protection Act, which introduced steps designed to regulate the financial sector’s activities and protect consumers. Additionally, the Emergency Economic Stabilization Act  created the Troubled Asset Relief Program to help restore stability to the mortgage market. While the MBS ETF market is now safer than it was in the years leading up to 2008, the occurrence of the financial crisis does illustrate the importance of portfolio diversification. 

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Mortgage-backed securities, while not without risk (no investment ever is), represent a safer opportunity today than in the years leading up to the 2008 crisis. With more investor protections in place, MBS ETFs once again offer the potential for steady, predictable, passive income. They also offer diversification similar to that of mutual and index funds, while affording individual investors an opportunity to take part in the mortgage backed securities marketplace.