The prospect of lower rates could translate to falling yields, forcing investors to diversify their fixed income portfolios. One area that’s been seeing renewed interest is mortgage-backed securities (MBS).
A data-dependent U.S. Federal Reserve may finally be seeing the economic data it needs to institute rate cuts. Notably, a weaker-than-expected jobs report could provide further signals that the economy would be weakening while the pace of inflation remained steady during the month of July.
“A notable deterioration in U.S. labor market conditions appears to be underway," said Scott Anderson, chief U.S. economist at BMO Capital Markets. "We have been forecasting this since the tariff and trade war erupted this spring and more restrictive immigration restrictions were put in place. Overall, this report highlights the risk of a harder landing for the labor market.’’
Furthermore, dissention on the direction of interest rates also tilts towards potential rate cuts. While the Fed elected to keep rates steady for a fifth consecutive time at its last decision meeting, two members were conflicted on the direction of rates — pushing for cuts as opposed to keeping them flat. It’s not a common occurrence, as the Fed is typically in unison when it announces a decision on interest rates. Notable economist Wolf Richter emphasized that the last time two governors dissented on the direction of interest rates was 1993. Whether the two members sway the rest of the Fed remains to be seen, but at least the prospect of cuts is part of the conversations behind closed doors.
If yields fall along with rates, alternatives can help supplant falling income — one of them being mortgage-backed securities.
One Fund for MBS Exposure
Exchange-traded funds (ETFs) offer easy access to MBS income, and one fund worthy of consideration has to be the Vanguard Mortgage-Backed Securities Index Fund ETF Shares (VMBS ). Its cost-effectiveness is apparent with its 0.03% expense ratio, or $3 per $10,000 invested. Paired with a 4.11% 30-day SEC yield (as of August 21) to further support its inclusion among MBS fund alternatives.
VMBS offers deep diversification, with over 1,400 holdings while the average benchmark is just over 1,000. Furthermore, it tilts towards higher quality credit by focusing on MBS assets guaranteed by quasi-governmental institutions. This includes government-owned corporations like Ginnie Mae and government-sponsored enterprises like Fannie Mae and Freddie Mac. The purpose of these quasi-government entities is to help provide liquidity in the secondary mortgage market. Therefore, their presence in the MBS ecosystem is imperative.
Average effective maturity is close to seven years, giving VMBS more of an intermediate bond fund skew. This also helps it seek a Goldilocks option between tempering rate risk while attaining yield.
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