In May 2018, mortgage rates across the U.S. climbed to levels higher than any seen for the previous seven years. While this obviously affects potential homebuyers around the country, it also has the chance of affecting fixed-income exchange-traded fund (ETF) investors. A recent report by ETF.com highlights some of the issues and a few of the funds affected by the climb in mortgage rates. (See also: Mortgage Rates Rise to Second Highest Level This Year.)

iShares MBS and Competitors Struggle

As of late May, the iShares MBS ETF (MBB) had its portfolio allocated to approximately 75% mortgage-backed securities (MBS) and 25% toward cash. The fund, with close to $12 billion in assets under management, has grown at a rapid clip, mirroring the ETF space in general. Indeed, in the first five months of the year or so, MBB generated net asset inflows of about $266 million. However, by mid-May of this year, MBB had also experienced net redemptions of $321 million. In an ever-growing ETF world, the fact that shares of MBB traded down to levels not seen for more than a year took some investors by surprise and caused a fair amount of alarm.

Lest it seem that MBB has been uniquely affected by the increase in mortgage rates, ETF.com also draws attention to the fund's primary competitor, the Vanguard Mortgage-Backed Securities ETF (VMBS). At $5.25 billion, VMBS is only about half the size of MBB in terms of assets under management. At the time of the report, VMBS allocated about 86% of its portfolio toward securities, with another 13% or so going toward cash. Another ETF in the mortgage-backed securities space is the SPDR Bloomberg Barclays Mortgage Backed Bond ETF (MBG), with a whopping 96% allocated toward MBS and 4% in cash as of the time of the report. Both of these competitors were in the red for the year as of late May. (For more, see: Top Mortgage-Backed Securities ETFs.)

Reasoning Behind the Struggle

Certainly, the rise of mortgage rates throughout the year has been unkind to the welfare of these ETFs, which are so heavily dependent upon the MBS space. However, there are other reasons that these ETFs in particular may have struggled of late. Treasury yields have also been climbing higher, reaching above 3% as of late May. It's common for MBS and Treasurys to be strongly correlated, with yields rising as prices tend to fall.

Aggregate bond ETFs centered around the Bloomberg Barclays US Aggregate Bond Index are also revealing. These funds tend to own a variety of segments of the bond market. So far in 2018, nearly every segment represented in these funds has been in the red. The Agg index is allocated roughly 28% to MBS, meaning funds that track it maintain a similar percentage of their portfolio in MBS as well. These funds include the iShares Core U.S. Aggregate Bond ETF (AGG), the Schwab US Aggregate Bond ETF (SCHZ) and the SPDR Portfolio Aggregate Bond ETF (SPAB). These ETFs all saw a rough start to the year, and many are trading at levels lower than anything seen in the past year. (See also: BND vs. AGG: Comparing Bond ETFs.)

However, some ETFs that have allocated more heavily to MBS have actually managed to outperform despite the rise in rates. Active aggregate bond ETFs have taken advantage of the fact that, while the MBS sector is down for the year, it is still not facing as much pressure as other portions of the bond space. The SPDR DoubleLine Total Return Tactical ETF (TOTL) allocates 53% of its assets toward MBS, making it roughly twice the allocation by percentage as compared with the Agg index. TOTL's mandate allows it to invest in a number of different fixed-income sectors around the world, and it has managed to outperform the Agg so far this year. TOTL has even outperformed its primary competitor, the PIMCO Active Bond ETF (BOND), which had about 34% of its portfolio linked to MBS as of late May.

While rising mortgage rates may be troubling for many in the ETF space, at least some of the funds focused on MBS have managed to turn relatively bad news into good. (For additional reading, check out: 3 ETFs to Take Advantage of Increased Mortgage Rates.)