A Cheap, Diversified, Mortgage-Backed-Securities ETF

Low costs, the makeup of its benchmark, and index-management expertise

lead to a Silver Analyst Rating for Vanguard Mortgage-Backed Securities ETF.
Phillip Yoo, 05/26/2017
Vanguard Mortgage-Backed Securities ETF VMBS provides market-cap-
weighted exposure to AAA rated U.S. agency mortgage-backed-securities
issued by Fannie Mae, Freddie Mac, and Ginnie Mae. This fund is one of the
lowest-cost options in the intermediate-government Morningstar Category. It
has tightly tracked the Bloomberg Barclays U.S. MBS Float Adjusted Index
since its 2009 inception. The fund's cost advantage, the makeup of its
benchmark, and Vanguard's index-management expertise are likely to
produce attractive risk-adjusted returns relative to its peers over a full
market cycle, underpinning a Morningstar Analyst Rating of Silver.
This fund delivers a higher yield than most of its peers that invest in agency
MBS because of its relatively larger investments in Fannie Mae- and Freddie
Mac-issued mortgage bonds. Unlike Treasury bonds, these bonds are not
explicitly guaranteed by the U.S. government, and they offer higher yields
than Treasuries with a comparable term. The fund's investments in Fannie
Mae- and Freddie Mac securities represented roughly 70% of the portfolio as
of March 2017. The rest of the portfolio is invested in Ginnie Mae securities,
which are guaranteed by the U.S. government. The fund focuses on
residential mortgage bonds even though it is part of the intermediate-
government category, which encompasses funds investing in all sorts of
government-related debt.
Despite the fund's sizable investments in non-government-guaranteed
bonds, it takes minimal credit risk. The portfolio is entirely invested in AAA
rated securities, the highest possible credit rating. Also, the fund's 4.4-year
duration is on par with its peers that focus on agency MBS.
Vanguard's index group has kept the fund's performance close to its
benchmark. From its November 2009 inception to March 2017, the fund
produced an annualized return of 2.81%, lagging its benchmark by 0.04% on
an annualized basis. This gap is less than its 0.07% management fee, which
is among the lowest in the category. Over the same period, the fund's
absolute and risk-adjusted performance was in line with its average agency-
mortgage fund peers.
Fundamental View
An agency MBS is a pool of residential mortgages assembled by government
agencies Fannie Mae, Freddie Mac, and Ginnie Mae. These entities were
created to facilitate mortgage lending and promote home ownership. The
agency-mortgage market had grown to more than $5 trillion at the end of
2016, and it is a major component of the taxable-bond universe. This
segment currently accounts for roughly 30% of the Bloomberg Barclays U.S.
Aggregate Bond Index.
Unlike a corporate or Treasury bond, an agency MBS carries prepayment risk.
There is uncertainty surrounding the timing of the principal payment because
the borrower can prepay the mortgage at any time without a penalty. This
prepayment risk is difficult to analyze because borrowers prepay their
mortgages not only for economic reasons such as low interest rates but also
for personal reasons such as moving for a job or marriage. Also, Fannie Mae-
and Freddie Mac-issued bonds carry higher credit risk than Treasuries and, as
such, offer slightly higher yields. This is because they do not carry the legal
backing of the U.S. government. However, investors price them under the
assumption that the government will step in if necessary to bail out these
privately owned government-sponsored enterprises.
The fund's investments in Fannie Mae- and Freddie Mac-issued mortgage
bonds mean it tends to have a higher yield than its mortgage-bond fund
peers that focus on government-backed Ginnie Mae securities. As of March
2017, Fannie Mae and Freddie Mac securities took up approximately 70% of
the fund. These securities offer slightly higher coupons than Ginnie Mae
bonds to compensate for default risk as they are not explicitly guaranteed by
the U.S. government. As of March 2017, this fund had an SEC yield of 2.2%,
about 10 basis points higher than its mortgage-fund peers.
This fund's credit and interest-rate risk profile is comparable to its peers that
focus on mortgage bonds. As of March 2017, the fund's duration was four
years, similar to its average peers.