Will Fed’s Exit Strategy Bury MBS ETFs?

by on December 2, 2009 | ETFs Mentioned:

Due to the role they played in spawning the recent global financial crisis, mortgage-backed securities are viewed by many as “portfolio poison.” As individual and institutional investors looked to dump these securities last year, the federal government was “forced” to acquire a huge MBS position. With signs of a sustainable recovery popping up, the Fed has reportedly begun considering ways to unwind this massive position, a policy move that could have a big impact on prices of MBS ETFs in coming months.

Despite some attractive yields and backing from agencies of the U.S. goverFOMC Meetingnment, most investors have been hesitant to buy up these securities, opting instead for less risky fixed income products. When the Fed’s decision to cut borrowing rates to almost zero failed to thaw frozen credit markets, they adopted additional emergency measures, buying up almost $1.5 trillion of government-guaranteed mortgage related securities and Treasuries. As the Fed’s balance sheet swelled, this demand helped to drive prices up and yields down.

Exit Strategy

Now that some degree of stability has returned, the focus turns to developing a plan to unwind these massive positions. In doing so, the Fed must walk a very fine line. Large-scale liquidations could sent prices plummeting, while incremental sales will hardly make a dent.

The Fed has begun to test a strategy focused on the use of “reverse repurchase” agreements, whereby the government would essentially lend out its MBS investments and promise to buy them back later. This would potentially avoid a spike in yields, but obviously wouldn’t completely distance the securities from the government’s balance sheet.

While some might take this statement as an indication that the Fed is considering other monetary policy options, such as raising rates, and that the rate hikes might come sooner rather than later. However, the Fed quickly dispelled this notion and made it crystal clear that this exercise doesn’t mark a change in policy. “Like the earlier rounds of testing, this work is a matter of prudent advance planning, it represents no change in policy stance, and no inference should be drawn about the timing of any change in the stance of monetary policy in the future,” said the New York Fed in a statement.

Furthermore, St. Louis Fed President Bullard was recently quoted as saying that if the Fed sticks to interest rate patterns after the last few recessions, rates will probably not rise until early 2012. This indicates that the Fed is much further away from even considering raising rates, especially when compared to emerging markets and other developed nations.

MBS ETFs

Investors in MBS ETFs have seen their fortunes reverse in recent months, with these funds delivering small but steady gains (a welcome departure from the extreme volatility of previous years). For investors considering a play on mortgage-backed securities, there are several ETFs that offer cheap, efficient exposure. While these funds are similar in many ways, such as issuer exposure, they are far from identical. For more head-to-head comparisons of potential ETF investments, sign up for our free ETF newsletter.

  • iShares Barclays MBS Bond Fund (MBB): By far the most popular MBS ETF, this fund has nearly $2 billion in assets, making it one of the world’s largest holders of mortgage-related assets. MBB has an S&P rating of AAA, and about 45% of its allocated to both FHLMC and FNMA (the remaining 10% or so is in securities issued by GNMA). As of November 30, MBB’s 30 day SEC yield, a standard yield comparison metric, was -0.16%, reflecting the effectiveness of the Fed’s action.

MBB

  • SPDR Barclays Capital Mortgage Backed Bond ETF (MBG): MBG is based on the same index as MBB, but these two funds are definitely not identical. MBG’s holdings are spread across 17 individual holdings, while the iShares ETF invests in 20 securities.

MBG

  • Vanguard Mortgage Backed Securities Index Fund (VMBS): This Vanguard ETF is a new arrival in the MBS ETF space, launching in November 2009. VMBS offers exposure similar to more established MBS ETFs at a significantly reduced rate: this fund charges an expense ratio of just 0.15%, compared to 0.34% for MBB and 0.20% for MBG.

Disclosure: No positions at time of writing.