2023-06-12 15:45:22 ET
Summary
- The matter of negative convexity of mortgage-backed securities remains the key consideration as far as betting on a potential rate reversal goes.
- We are beginning to see signs of wholesale disinflation and loosening of the job market, so we are getting closer to when the Fed will have an opening to reverse.
- But negative convexity reduces the appeal of iShares MBS ETF as an instrument to bet on the turnaround, even though it has the innate leverage to rate news due to longer duration.
- You also get a better YTM on similar duration ETFs that own Treasuries. MBB is beaten out definitively.
The iShares MBS ETF ( MBB ) is a longer-duration play with very low credit risk that could be interesting for speculators looking to get exposed as we see higher unemployment claims and abating wholesale inflation. However, we see some elements in MBB that make it relatively unappealing as a pick. Firstly, Treasury exchange-traded funds ("ETFs") with similar durations yield better, and secondly, negative convexity stymies upside. Overall, MBB is not the pick.
MBB Breakdown
The key data for MBB is their effective duration first, which is 5.99 years, and their YTM, which is 4.6%. The expense ratio for the ETF is very low at 0.06% . Because MBB tracks mortgage-backed securities, there is the phenomenon of negative convexity to worry about, which is that the downside is the same as other instruments with similar durations and low AAA credit risks, but the upsides are diminished. This is because as rates fall and mortgage-backed securities ((MBS)) price up, refinancing causes some of the instruments to vanish, and the higher rate returns can't be lived out for their full maturity. Since the matter of rates eventually falling is a critical question for speculators following the interest and inflation rate speculation, this fact is essential for investors who'd be looking at MBB.
An alternative ETF would be the iShares Core 5-10 Year USD Bond ETF ( IMTB ), which has a low expense ratio of 0.07% . This is barely higher than the MBB, with a 6.13-year duration and a 4.68% YTM, compensating investors for the slightly higher duration risk. However, this is still very in line with the implied pricing on the MBB. The pluses are that IMTB does not suffer from negative convexity, and ultimately it is a Treasury ETF - you don't have to muck around in securitized product markets based on real estate.
Bottom Line
The matter of peak rates is becoming relevant again now that the debt ceiling issue has passed and that everyone is ready and confident for regulatory bodies to do their jobs vis-à-vis the banking system. Certain death spirals between sovereign debt and banking stability are also out of the picture now - no Europe-style doom loop .
Key economic data have been the unemployment claims in the U.S., which were higher than expected showing that the labor market is no longer ultra-tight, and also the fact that wholesale metrics around inflation seem to be calming down meaningfully. Major economies like Japan also seem to be entirely backing off from any threat of raising rates at all, too. While CBs are likely to stay the course and make totally sure that there's not going to be any more aggressive inflation spikes, since there is the El Nino concern this year and the ongoing conflict in Ukraine that could create some supply flare-ups, inflation is clearly coming down thanks to the cooler demand environment - we saw it first in commodities, which has high transmission from economic change. There could be a reversal of rates within the year, and much higher rates are very unlikely at this point.
Duration is no longer a problem, it's actually desirable for speculators.
While you want the duration to get some leverage to changes in rates, when they eventually have space to reverse as markets expect they'll have a year from now (we think sooner is possible), you want to make sure you're speculating with the right instrument. Low credit risk is great, since it keeps the rate speculation ceteris paribus.
iShares MBS ETF has that, but even better is if you can avoid that negative convexity. Keeping the equivalent duration to MBB gets you to IMTB, and the expense ratios are basically the same. Considering how existential refinancing concerns are for people who've taken out a mortgage, it's important to not underestimate negative convexity. We just think that IMTB has MBB beat, we'd not consider it.
For further details see:
MBB: Worse Than Long-Duration Bonds On Rate-Reversal Speculation