iShares MBS ETF – More Pain Ahead (NASDAQ:MBB)

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Thesis

The iShares MBS (MBB) ETF tracks the results of an index composed of pass-through mortgage securities backed by US government agencies. The index in question is the Bloomberg US MBS Index Total Return Value Unhedged USD. It tracks transfer securities backed by fixed rate agency mortgages guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). Index construction involves grouping individual pools of TBA deliverable MBS into aggregates or generics based on program, coupon and vintage. Agency MBS are mortgage-backed securities issued by government-sponsored companies to keep mortgage rates low and home ownership accessible. Ultimately, they have an implied US government guarantee on top of the collateral that backs the transaction, so they are AAA rated and their main risk is interest rate fluctuations. As it embarked on quantitative easing, the Fed bought MBS for its balance sheet in addition to US Treasuries. It is estimated that the Fed currently holds 30% of all outstanding MBS securities on its books. As rates rise and the Fed seeks to unwind its balance sheet, MBS bonds will underperform due to several factors: i) loss in value due to rising rates, ii) loss of market demand for bonds without the Fed’s offer (essentially widening the spread). MBB has a duration of 4.6 years and is already down -3% year-to-date. Much like its long Treasuries counterpart, the iShares 7-10 Year Treasury Bond (IEF) ETF, MBB will continue to lose value until there is rate stabilization and a clear picture of the end of the year. the rise of the Fed. MBB has the added wrinkle of the spread between MBS and Treasuries which we believe will widen as the Fed supply disappears and this will act as another drag on performance. We expect a further -6% price loss this year due to rates and widening spreads, which will be partially mitigated by the fund’s dividend yield. We have an To sell rating on MBB. A retail investor would be in a better position to divest all of MBB’s holdings and return at the end of the year for a better entry point.

Assets

The fund holds MBS securities directly or via TBAs:

assets

Top Holdings (Fund Fact Sheet)

To-be-announced, or TBA in bond trading, serves as a contract to buy or sell an MBS on a specific date, but it does not include information regarding pool number, number of pools, or the exact amount that will be included in the transaction. Indeed, TBAs are an effective way to access the MBS market.

All securities are rated AAA given their collateral and their implicit government guarantee:

funds

Credit Rating (Fund Fact Sheet)

The fund generally buys securities with shorter maturities:

funds

Maturity Breakdown (Fund Fact Sheet)

This maturity profile gives a fund duration of 4.62 years

Interest rate risk

The fund has a duration of 4.6 years and a slightly higher WAL of 5.72. This puts it in the middle bond duration bracket. The general price development given a 1% increase in rates for the duration bracket is as follows per Vanguard:

bind

Duration implications (vanguard)

The best proxy given the duration of the fund is the 5-year Treasury rates:

rates

5-year Treasury rate (Fed)

5-year rates have risen considerably recently to reach the 2% threshold. Given the current high inflation and the expected aggressive course of the Fed, we expect 5-year rates to test the 2.5% to 3% range this year. Based on our duration matrix, this implies another 5-6% decline in MBB bond prices.

Spread to treasury bills

Mortgage-backed securities are AAA rated and generally have an implicit government guarantee in addition to the guarantee they refer to (real estate shares), therefore an objective investor would expect them to trade quite closely with US Treasuries. This actually happens and there are entire trading teams dedicated to the spread between mortgages and treasuries. As the Fed engaged in quantitative easing and bought MBS, the spread narrowed to historic lows:

GSM

MBS Spreads (GSAM)

As rates rise, the Fed begins to unwind its balance sheet and investors generally turn away from longer duration fixed income securities. We expect this gap to normalize or even widen. The net effect will be a headwind for MBB and further underperformance.

Performance

The fund posts solid total returns over 5 and 10 years:

to return to

5-year total return (seeking alpha)

10 years

10-year total return (seeking alpha)

We can see a very good correlation between MBB and IEF vehicles which only started to diverge at the end of 2019 when the mortgage/cash basis changed. MBB has proven to be a good tool for buy-and-hold diversification, albeit with modest annual returns considering its asset class.

As the Fed became more hawkish, MBB began to lose value:

to return to

Total Return (Seeking Alpha)

Conclusion

MBB is an ETF that tracks an index of mortgage-backed securities. The instrument is a good buy-and-hold vehicle for the asset class, comparing favorably to its counterpart IEF treasury bills. A wise investor must nevertheless recognize that we have now entered an environment of monetary tightening. Therefore, holding MBB will result in only negative total returns over the next twelve months. We expect a further -6% price loss this year due to rates and widening spreads, which will be partially mitigated by the fund’s dividend yield. We have an To sell rating on MBB. A retail investor would be in a better position to divest all of MBB’s holdings and return at the end of the year for a better entry point.

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