MBB Gets A Discount For Past Transgressions In The Category (NASDAQ:MBB)

The iShares MBS ETF (NASDAQ:MBB) is an ETF that contains mortgage backed securities sponsored by the GSEs like Fannie Mae (OTCQB:FNMA). These are mortgages that are originated by banks, but then sold off the balance sheets if their risk is low enough, or insured by private mortgage insurers to be low enough, to companies like Fannie Mae that create a secondary market for these loans and allow banks to keep originating more without having to bloat their risk-weighted assets and run into capital control issues. These mortgages are packaged along the way into portfolios, which are then tranched up into different risk categories based on seniority of claims to the portfolios of mortgage’s down-payment cash flows. MBB contains AAA rated MBS, and we think that they trade at an unwarranted discount.

Comparing MBB and GOVT

Both the MBB and the iShares U.S. Treasury Bond ETF (GOVT) share a lot of the same characteristics. Their durations are both around six years, and their credit ratings are all AAA. In GOVT’s case it’s because the Treasuries are backed by the de facto AAA standard of the US government, and in the MBS’s case it’s because the rating agencies have decided that the senior tranches can be virtually assured their cash flows.

Expense ratios are basically the same at 0.05% for the GOVT and 0.06% for the MBB.

Their duration risk is the same, and therefore their interest rate sensitivity is the same, and this can be seen in the fact that both have seen YTD declines of about 12%.

When looking at the detailed holdings of the ETFs, the differences start to appear in the YTMs. Average yield to maturity is 4.5% for the MBB while it’s 4.2% for the GOVT. The expense ratio differential is negligible, so the yields are simply higher on MBB for no additional credit risk, nor duration risk given the same vector of declines YTD for each.

This seems to indicate less confidence around the MBS asset class, which of course is marred with the reputation of being the veil behind which the excesses that lead to the financial crisis were hidden. Since we are confident in the governance of these asset classes nowadays, we’d rate the MBB as relatively undervalued compared to a standard Treasury ETF.

Is now the time for MBB?

The question is whether the timing is becoming right for an ETF like the MBB. In our opinion it is, and this is based on our house view concerning the inflation and interest rate environment.

Inflation expectations are falling and have now reached June 2021 levels, which were not alarming and came long before rate hikes were conducted. Otherwise, inflation is also beginning to ease. Both point to good conditions for the prices of mortgages as the Fed, especially on the inflation expectations side, will have less reason to keep rates high, arguably very little reason at all. The relative misfortunes of other economies in the EU and China are also a cushion to the US rate situation, where their demand is taking pressure off global prices like basic materials and commodities.

This could be a peak moment for YTMs, and the peak moment for fixed income instruments in general. With relative value in MBBs, they might be the AAA allocation for the current environment.

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