Due to the COVID-19 pandemic, mortgage rates across the U.S. have fallen to record lows. While this affects potential homebuyers and homeowners around the country, fixed-income exchange-traded fund (ETF) investors are also experiencing the benefits.
- Exchange-traded funds (ETFs) that invest heavily in mortgage-backed securities (MBS) have enjoyed the decline in mortgage rates through higher share prices.
- However, MBS-focused ETFs have underperformed other bond ETFs have less exposure to MBS.
- This comes as MBS experience negative convexity—as mortgage rates go up the price of an MBS goes down by a greater amount than the price goes up when rates go down by the same amount.
iShares MBS, Competitors Rebound
The average 30-year mortgage rate nearly hit 5.0% in 2018, before beginning a steady decline, all the way to 2.68% in December 2020. Average rates still stood at just 3.07% as of October 2021. In November 2018, when mortgage rates were near their recent peak, the iShares MBS ETF (MBB), which invests heavily in mortgage-backed securities (MBS), traded at its lowest level since the financial crisis—trading right at $100.
As rates rose, the value of the MBS held by MBB rose— in many cases faster than other bonds. MBS are more interest-rate sensitive because rate changes affect the mortgage-backed bonds and the mortgages within the bond. Then as rates begin to fall, shares of MBB were pushed higher—hitting an all-time high in early 2020.
Bond-focused ETFs tend to be inversely correlated with interest rates, whereas these yields (and other benchmark yields) increase, the value of bonds fall, and vice versa.
MBB has its portfolio allocated to approximately 80% mortgage-backed securities (MBS) and 20% toward cash. The fund, with close to $26 billion in assets under management, has grown at a rapid clip, mirroring the ETF space in general.
MBB has not been the only MBS-focused ETF that has been uniquely affected by the increase in mortgage rates. The Vanguard Mortgage-Backed Securities ETF (VMBS) is one of MBB's main competitors, with $16.8 billion in assets. The other is the SPDR Portfolio Mortgage-Backed Bond ETF (SPMB), which has $4.2 billion in assets. Both of these have a greater weighting toward MBS when accounting for cash holdings.
The MBB and VMBS have traded in relative lockstep for the last decade, with MBB slightly outperforming over that period. SPMB has been a notable laggard over the last decade, and that underperformance has continued over the last year or so. Now, despite the somewhat positive performance over the last few years for the MBS ETFs, their returns have been capped, especially compared to other bond-focused ETFs.
The decline in mortgage rates has been kind to MBS ETFs. However, these ETFs have underperformed other bond-focused ETFs that have less exposure to the MBS space. As mortgage rates have fallen, so have Treasury yields, which are pushing fixed income security prices higher.
Other fixed income securities (besides MBS) tend to rise quickly as they don't have the same reinvestment risk when mortgage rates fall. As mortgage rates decline the number of refinances increases, which pushes the maturities down.
Aggregate bond ETFs focused on a variety of segments of the bond market. So far, over the last three years, nearly every segment represented in these funds is higher. The Bloomberg US Aggregate Bond Index is allocated roughly 27.4% 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 were all at multi-year lows toward the end of 2019, before rebounding to all-time highs in 2020. All three have outperformed the trio of MBS ETFs—MBB, VMBS, and SPMB—over the last three years.
MBS Negative Convexity
Mortgages and MBS experience negative convexity. When mortgage rates go up, the price of MBS goes down by a greater amount than the price goes up when rates go down by the same amount. As rates fall, MBS prices go up less (compared to other bonds) because of refinancing, where the maturity of mortgages becomes shorter. However, when rates rise, MBS prices fall by a greater amount because the expected maturity of the mortgage becomes longer.
Let's look back at MBB. For the three years before November 2018 (when mortgage rates hit recent year highs), MBB shares fell by 6.5%. Over those three years, rates rose by just under one percentage point. Meanwhile, for the three years following November 2018, shares were up just 6.26% despite mortgage rates having fallen by nearly 1.8 percentage points over that period.