iShares MBS ETF is fairly fairly priced (NASDAQ:MBB)

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Vertigo3d

The iShares MBS ETF (NASDAQ: MBB) is an ETF that holds mortgage-backed securities from GSEs. These MBS have a high credit rating due to the way they were securitized. The implicit assumptions are that the risks are diversified and performance will mainly depend on the risk of default perceived by the markets, although the tranches held by the ETF are likely to be investment grade given the AAA credit ratings. Yields are good here and probably mostly variable. Duration risks are negated, but we warn investors that the risk of capital appreciation diminishes in employment, on which performance will depend more. We think the return profile here is good though. All in all, a buy, but cash also makes sense, with markets likely to offer discounts soon.

Breakdown of MBB

The YTD ETF’s price declines are only around 8%, due to limited exposure to duration risk thanks to the fact that mortgages tend to be floating rate. The risk from a credit risk perspective is expected to be minimal as the ETF likely holds the top of the MBS tranche stack. The maturity profile is technically long-term, but again it doesn’t affect duration due to floating rates.

What are the risks here? Mainly employment figures, since that is what activity in the mortgage world is mainly linked to. Mortgage insurance is paying attention to this, which means markets understand that default rates are rising primarily due to borrowers’ employment issues. Logic.

There aren’t that many systematic risks and contagion in the system right now, so a liquidity catastrophe is unlikely. But we do note that funding from frontline lenders has already dwindled and mortgage companies are going bankrupt, but primarily because of lower volumes and not because of defaults.

Remarks

The average YTM of MBBs is 3.7%, which gives a nice spread, especially for a AAA credit rating, compared to benchmark rates around 2%. What to worry about? From a performance perspective, the ETF could move if unemployment starts to spike as the economy declines and rates continue to rise. Economic decline may come soon as business spending may be taken into account by consumers. Another thing to consider is that MBS AAA credit ratings come from securitization, not the underlying quality of mortgages. No mortgage can be rated AAA individually, but seniority within the stack relative to mortgage pool cash flow can provide AAA security. Again, while national markets are going to be influenced by the same factors globally and federally, likely with strong correlation in the US submarkets, that seniority still holds, and there shouldn’t be any issues with massive liquidity like during the financial crisis since lending standards have now ensured that the information asymmetries that crippled the market should not be present.

We don’t think the economy is so overleveraged as the current declines will lead to severe deleveraging. That would really be the worst case scenario for any asset class, where of course mortgage defaults would get pretty scary. Although the top tranche holdings of MBS can prevent you from losing principal. Consumer spending will plummet in the coming economic regime, but unless unemployment soars, the economy will suffer mainly due to lower investment and lower corporate profits caught between inevitable wartime inflation. and reduced growth.

From a yield perspective, MBB looks quite attractive. We trust the security of cash flow and do not see excessive risk. Still, it’s not much better than cash when cash gives you options in the market where things could go down a lot. With unemployment still likely to affect the price, we are not sure that the fair spread on benchmark rates and the flexibility of rate hikes is enough to put money there. All in all a buy, but cash also makes sense right now.

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