The iShares MBS ETF (NASDAQ:MBB) is an ETF that owns mortgage backed securities coming out of the GSEs. These MBS’ have a high credit rating on account of how they’ve been securitized. Implicit assumptions are that the risks are diversified, and the performance will depend primarily on default risk perceived by markets, even though the tranches owned by the ETF are likely top-tier given the AAA credit ratings. The yields are good here and likely mostly variable. Duration risks are nullified, but we do warn investors that the risk in capital appreciation declines in employment, to which performance will be more levered. We think the return profile here is good though. On balance a buy, but cash makes sense too with markets likely to offer discounts soon.
The price declines of the ETF YTD are only about 8%, owing to limited exposure to duration risks thanks to the fact that mortgages tend to be variable rate. The risk from a credit risk perspective is supposed to be minimal as the ETF owns likely the top of the stack of tranches of the MBSs. Maturity profile is technically long term, but again it doesn’t effect duration due variable rates.
What are the risks here? Primarily to employment figures, since that is what activity in the mortgage world is primarily levered to. Mortgage insurance pays attention to it, which means markets understand that default rates go up primarily in relation to issues with borrowers’ employment. Makes sense.
There isn’t that much systematic and contagion risk in the system now, so a liquidity disaster is unlikely. But we do note that already financing for frontline lenders has decreased, and mortgage companies are going out of business, but mainly because of falls in volumes not because of defaults.
The average YTM of the MBB is 3.7%, which gives a nice spread, especially for a AAA credit rating, over reference rates at around 2%. What is there to worry about? From a performance perspective, the ETF could move if unemployment starts to spiral as the economy enters decline and rates continue to rise. Economic decline could come soon as corporate spending may see a reckoning from the consumer side. Another thing to consider is that MBS AAA credit ratings come from securitization, not underlying mortgage quality. No mortgage individually could be AAA rated, but the seniority within the stack to cash flows from the pool of mortgages can provide AAA security. Again, while home markets are going to be driven by the same global and federal level factors, likely with a lot of correlation in US submarkets, that seniority still stands, and there shouldn’t be massive liquidity problems like during the financial crisis since lending standards have now made it that the information asymmetries that brought the market to a standstill should not be present.
We don’t think the economy is so overleveraged where current declines will cause a serious deleveraging. That would really be the worst case scenario for all asset classes, where of course mortgage defaults would get pretty scary. Although top-tranche holdings in MBS might stop you from losing principal. Consumer spending will fall in the upcoming economic regime but unless unemployment rockets, the economy will primarily suffer on account of lower investment and lower corporate profits stuck between some inevitable war-based inflation and lowered growth.
From a yield perspective, MBB looks pretty interesting. We trust the security of the cash flow and don’t see excessive risks. Nonetheless, it’s not so much better than cash when cash gives you options in the market where things could decline a lot. With unemployment still likely to effect the price, we’re not sure the fair spread over reference rates and rate hike flex is enough to park money into it. On balance it’s a buy, but cash makes sense too right now.
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