Investors Move Out of Mortgage-Backed Funds Amid Rate Volatility

They say home is where the heart is, but these days, it’s definitely not where the yield is.

ETFs that hold US mortgage-backed securities recorded a net $2.4 billion outflow in September, the most since 2020, according to Bloomberg data. While investors were bullish on the sector at the beginning of the year, the S&P US Mortgage-Backed Securities Index is now down over 3% year to date. With rising interest rates, homeowners are less likely to refinance their loans, and thus investors in mortgage securities are exposed to lower yields than those available in the rest of the market. 

“Speaking broadly, investors are demanding higher terms for long-duration debt, but I don’t think you can understate the importance of the change in the shape of the yield curve playing a big role here as well,” said Joe Bullard, active fixed-income strategies analyst at Morningstar, comparing the Fed funds rate with longer-term rates. “Agency mortgage spreads are also widening, so that causes further losses for agency mortgage-backed securities. That’s kind of a double whammy.” 

Moving to the Cheap Seats

While most funds in this category experienced outflows in September, a few low-cost funds saw money come in. “Some of the outflows from the rest of the category into these ETFs could be the result of tax-loss harvesting from investors exiting declining positions and agency mortgages in more expensive funds that they’ve held, locking in those capital losses and rotating into lower-fee offerings,” Bullard said. 

• BlackRock’s iShares MBS ETF (MBB), the largest fund in this category, notched about $2.7 billion in September net outflows and is down about 3.2% this year, according to ETF.com data. About $1.2 billion of these outflows were due to changes to the company’s model portfolios, per Bloomberg. 
• The Vanguard Mortgage-Backed Securities ETF (VMBS), the category’s second-largest fund, recorded about $200 million in inflows. The iShares Mortgage-Backed Securities Active ETF (MBBA) also saw about $562 million in net inflows in September, both potentially due to their low fees relative to the rest of the category. 
• The Simplify MBS ETF (MTBA) and the Schwab Mortgage-Backed Securities ETF (SMBS) both had their largest recorded monthly outflows in September, according to Bloomberg, losing about $342 million and $246 million, respectively. 

Short and Sweet: While investors were slightly more bullish on mortgage-backed securities in the beginning of the year and into spring, inflation expectations now have investors moving into shorter-term bonds that are less subject to rate volatility, Bullard said. For example, the iShares 0-3 Month Treasury Bond ETF (SGOV) recorded nearly $6 billion in September inflows. “Longer-term rates are more impacted by inflation expectations, and with oil prices rising so dramatically in a short period of time … that has definitely had a big impact on inflation levels across the broader economy,” Bullard said. “Many are anticipating further rate hikes from the Fed moving forward.”