The Impact of Rising Mortgage Rates on ETFs

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The Impact of Rising Mortgage Rates on ETFs

Mortgage rates have reached historic lows throughout the United States as a result of the COVID-19 epidemic. While homeowners and prospective homebuyers throughout the nation are impacted, investors in fixed-income exchange-traded funds (ETFs) are also benefiting from this.

Key Takeaways

  • The drop in mortgage rates has benefited exchange-traded funds (ETFs) that invest extensively in mortgage-backed securities (MBS) by driving up share prices.
  • But MBS-focused ETFs have done worse than other bond ETFs with lower MBS exposure.
  • Due to negative convexity, which occurs when mortgage rates increase more than they decrease, the price of an MBS decreases more when rates increase than when rates decrease by the same amount.

iShares MBS, Competitors Rebound

Before starting a gradual fall that will bring the average 30-year mortgage rate to 2.68% in December 2020, the rate almost reached 5.0% in 2018. As of October 2021, the average rate was still under 3.07%. The iShares MBS ETF (MBB), which invests mainly in mortgage-backed securities (MBS), traded at its lowest level since the financial crisis—right around $100—in November 2018, when mortgage rates were close to their previous high.

As rates increased, the value of the MBS that MBB owned increased—often more quickly than the value of other bonds. MBS are particularly susceptible to interest rate fluctuations since both the mortgage-backed bonds and the mortgages included inside them are impacted. The shares of MBB were then driven upward as rates started to drop, reaching an all-time high in early 2020.

When these yields (and other benchmark yields) rise, the value of bonds declines, and vice versa, according to the general rule for bond-focused ETFs.

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About 80% of MBB’s portfolio is made up of mortgage-backed securities (MBS), with the other 20% going to cash. The fund, which now manages close to $26 billion in assets, has expanded quickly, following the overall trend of the ETF market.

The rise in mortgage rates has not just had a particular impact on the MBB-focused ETF. With $16.8 billion in assets, the Vanguard Mortgage-Backed Securities ETF (VMBS) is one of MBB’s primary rivals. The other is the $4.2 billion-asset SPDR Portfolio Mortgage-Backed Bond ETF (SPMB). When cash holdings are taken into account, both of them favor MBS more.

For the last ten years, the MBB and VMBS have traded in almost lockstep, with the MBB marginally outperforming. Over the last ten years, SPMB has been a glaring underperformer, and this underperformance has persisted over the past year or two. The MBS ETFs’ gains have now been constrained, particularly when compared to other bond-focused ETFs, despite the fact that they have had a reasonably favorable performance over the last several years.

MBS Underperformance

The MBS ETFs have benefited from the drop in mortgage rates. These ETFs, however, have done worse than other bond-focused ETFs with less exposure to the MBS market. Treasury yields have decreased along with mortgage rates, driving up the cost of fixed income securities.

As they don’t have the same reinvestment risk when mortgage rates fall, other fixed income products (other than MBS) often increase swiftly. The maturities are pushed down as a result of the rise in refinances when mortgage rates fall.

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Bond market sectors were the subject of aggregate bond ETFs. Nearly every category represented in these funds has increased thus far during the last three years. MBS make up around 27.4% of the Bloomberg US Aggregate Bond Index, which means funds that follow it keep a comparable proportion of their portfolio in MBS.

These funds consist of the SPDR Portfolio Aggregate Bond ETF, the Schwab US Aggregate Bond ETF, and the iShares Core U.S. Aggregate Bond ETF (AGG) (SPAB).Toward the end of 2019, these ETFs were all at multi-year lows before rising to all-time highs the following year. Over the last three years, all three have beaten the trio of MBS ETFs (MBB, VMBS, and SPMB).

MBS Negative Convexity

MBS and mortgages both exhibit negative convexity. When mortgage rates increase, the price of MBS decreases more than it increases when rates decrease by the same amount. Because of refinancing, where the duration of mortgages shortens, MBS values increase less when rates decline (relative to other bonds). The longer the estimated term of the mortgage gets, the more the MBS values decline when rates climb.

Now let’s review MBB. Prior to November 2018 (when mortgage rates reached previous year highs), MBB shares had a 3.0-year decline of 6.5%. Rates increased by slightly about one percentage point throughout those three years. While mortgage rates dropped by approximately 1.8 percentage points during the three years that followed November 2018, shares rose only 6.26% during that time.

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