The securitized corner of the fixed income market, or those bonds backed by underlying assets, is massive. But the investment-grade landscape of asset-backed bonds is largely dominated by residential mortgage-backed securities (MBS).
MBS, which are accessible to advisors and retail investors via ETFs such as the WisdomTree Mortgage Plus Bond Fund (MTGP ), are favored by some conservative income investors. That’s because a significant portion of MBS are backed by U.S. government agencies. And that means these bonds possess little credit risk. That’s a plus, when MTGP is enhanced by being actively managed. However, MBS have some unique traits relative to other bonds. That underscores the utility of funds like MTGP. It also underscores the need for education regarding this corner of the bond market.
For starters, unlike Treasuries and municipal bonds, monthly payments distributed to investors by MBS, including MTGP holdings, can fluctuate depending on homeowners’ monthly payments and if they paid more or less than what was owed. There are other factors to consider, too.
Mortgage Plus Bond Fund MTGP Has Advantages
One of the biggest risks associated with holding an individual mortgage bond — one that can potentially be mitigated with ETFs like MTGP — is prepayment risk. In simple terms, that’s a homeowner paying off their mortgage early. That’s is great for them, but not so much for MBS holders.
“This is a risk for investors, as they are receiving their money back at a time when interest rates have fallen, meaning they may have to reinvest the proceeds into lower-yielding investments,” noted Collin Martin of Charles Schwab. “Today, prepayment risk seems relatively low because so many homeowners locked in historically low interest rates. So it would likely take a large drop in mortgage rates to make it economically advantageous for many homeowners to refinance and pay off their original mortgages.”
On a related note, MBS are also subject to extension risk. That’s more of an issue when interest rates are high. That means homeowners are less likely to pay mortgages off before they expire. That can lead to MBS holders getting their principal back later than expected. And related to that, MBS — including MTGP holdings — typically feature monthly principal and interest payments. Most bonds simply deliver the latter.
Near-Term-Allure
MBS are long-term investments. But it’s worth noting the asset class offers near-term allure from a yield perspective as highlighted by MTGP’s embedded income yield of 5.3%.
“Average yields on MBS are often considered relative to the 10-year Treasury yield. Over the past 15 years, the Bloomberg US MBS Index offered an average yield advantage of roughly 58 basis points (or 0.58%) over the 10-year Treasury yield. The yield advantage is a little bit higher today, at 68 basis points,” added Martin.
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