MTBA ETF: A Different MBS Strategy

Introduction

Have a home mortgage, then you are part of an MBS somewhere, grouped with similar mortgages based on rate, length and other factors. This has made it easier for the average US homeowner to get a mortgage versus pre-MBS days.

If indeed the FOMC is done or at least close to declaring more rate hikes aren’t needed to meet their inflation target, increasing a portfolio’s fixed income allocation into bonds and away from short-term CDs, who would see higher reinvestment risk. The newly formed Simplify MBS ETF (NYSEARCA:MTBA) provides features for risk-averse bond investors: short duration and investment-grade debt. While the strategy sounds superior to other ETFs that invest in mortgages, I give it a Hold until I see some performance history.

Simplify MBS ETF review

Seeking Alpha describes this ETF as:

The Simplify MBS ETF is managed by Simplify Asset Management Inc. The fund invests directly and through derivatives in mortgage-backed securities of maturities from 3 to 10 years. It uses derivatives such as swaps, options, forwards, and futures to create its portfolio. The investment seeks to provide total return consistent with preservation of capital and prudent investment management. The fund invests at least 80% of its net assets in mortgage-backed securities. The advisor defines MBS as any agency or non-agency residential or commercial mortgage-backed security and any futures contract, forward agreement, swap contract, or option linked to the preceding. It is an actively managed exchange-traded fund. MTBA just started on November 6, 2023.

Source: seekingalpha.com MTBA

According to the managers, MTBA will focus on buying newer MBS, which have provided higher coupons as well as higher yield to maturity compared to the MBS which comprise the Bloomberg U.S. MBS Index, which covers the entire MBS market.

MTBA has already amassed $144m in AUM. Management fees are set at 25bps, but there is a 10bps waiver in place until October 31, 2024.

Simplify states these details about their strategy:

• MTBA will initially invest in Federal National Mortgage Association (Fannie Mae) 6.0% coupon bonds.
• This exposure will be obtained via investments in To-Be-Announced (TBA) contracts, which are MBS forward contracts.
• TBA contracts provide greater liquidity than buying MBS directly, as well as having greater operational and tax simplicity.
• The contracts will be rolled monthly as they approach expiration.

More on the “whats/whys” is covered in the Portfolio strategy part of this article.

What is a TBA?

To be announced, or TBA in bond trading, is a term that describes forward-settling of mortgage-backed securities (MBS) trades. Pass-through securities issued by Freddie Mac, Fannie Mae, and Ginnie Mae trade in the TBA market, and the term TBA is derived from the fact that the actual mortgage-backed security that will be delivered to fulfill a TBA trade is not designated at the time the trade is made. These securities are announced 48 hours prior to the established trade settlement date.

Source: investopedia.com/terms

A TBA Factsheet provided these details for the construction of a TBA:

In a TBA trade, similar to other forward contracts, the two parties agree upon a price for delivering a given volume of agency MBS at a specified future date. The main feature of a TBA trade is that both sides agree upon the six general parameters of the securities to be delivered: issuer, maturity, coupon, price, par amount, and settlement date.

Source: sifma.org Factset PDF

Holdings review

As stated, the TBA holdings roll each month. The Treasury bills can (and will) serve as collateral for the TBA forward contract exposures. By rolling each month, it should reduce both the duration, current 3.5 years, and interest rate risk. For investors who want a longer duration, which is good when rates are falling, there are other ETFs that can be added for that feature.

Distributions review

No distributions have been made so far, but will be monthly once they start. With the primary investment being 6% coupon TBAs, that seems like a good educated guess on my part of what to expect.

Portfolio strategy

To keep this simple, the strategy discussion will be based on how investors might maximize their results within the duration and rating limits they set to limit their risk profile. Simplify has a great video on why they believe the MTBA ETF can be used to achieve that for conservative bond investors. The following points are pulled from that video.

The first chart explains what Mortgage Backed Securities, or MBS, are as this is what a TBA will comprise. If you have a mortgage, there is a good chance it was placed in a pool, which then was grouped with other pools into an MBS. This has made the US mortgage market more liquid, less risky for mortgage providers and thus easier for homeowners to obtain home financing.

While guaranteed by the US Government, the same as Treasuries are, MBS historically yield more. Some of this is due to the fact the mortgages underlying the MBS can be prepaid, which adds uncertainty that investors want to be compensated for. After years of very low mortgage rates, pre-payment risk is down but would balloon when homeowners can refinance the current 7% rates into even 5% mortgages.

Adding to the attractiveness of MBS assets over USTs is the current wide spread between the yields of the two asset classes. With mortgage rates at decades high, the prepayment risk has increased, which helps explain the spread increase since the FOMC started pushing up rates. When the spread shrinks, MBS assets should reap most of the benefit.

We see the same change in spreads between MBS and Investment-grade Corporate bonds. The next table shows why MTBA focuses on new MBS with a 6% coupon versus owning older, lower coupon MBS assets. If the FOMC pulls off the “soft landing” scenario, again the spread would shrink more to the benefit of the MBS holders.

The 6% coupon not only yields more, their YTM is higher while having a shorter duration. Since most MBS-invested ETFs are passively managed, they own the whole index, which is heavily weighted to the older MBS assets, thus an advantage the actively-managed MTBA has over these ETFs.

Besides the above, the video explains why Fannie Mae versus Ginnie Mae and Freddie Mac and TBAs instead of directly in MBS assets. They also provide how MTBA fits into an investor’s fixed income allocation.

The following quote is from Harley Bassman, Managing Partner at Simplify Asset Management:

“MTBA is the only way for civilians (non-professionals) to readily access the higher-coupon Mortgage-Backed Securities (MBS) that have been issued in 2023. This is in contrast to the MBS Index, which is mostly populated by the 2.0% to 3.5% MBS issued during QT from 2020 to 2022.

The market professionals (BlackRock, Gross, Gundlach, etc.) who have been pounding the table about the superior value of MBS are referring to these newly issued MBS, not the legacy low coupon MBS. Presently, most of the MBS mutual funds and ETFs try to mimic the Index, which, as noted, is 72% legacy bonds.”

Final thoughts

Assuming the yield should be close to the 6% coupon mortgages held, how does that yield compare to what investors could earn by changing the risk level (quality, duration) by owning different ETFs? As a starter, here are some possible alternatives. I included an article link if I covered the ticker.

• iShares MBS ETF (MBB): 3.47%
• US Treasury 2 Year Note ETF (UTWO): 4.01% Article link
• iShares 20+ Year Treasury Bond ETF (TLT): 3.56%
• PIMCO Investment Grade Corporate Bond Index (CORP): 4.24% Article link
• iShares 0-5 Year High Yield Corporate Bond ETF (SHYG): 6.61% Article link
• iShares iBoxx $ High Yield Corporate Bond ETF (HYG)

As stated above, my Hold rating is due to MTBA being a new ETF. If the yield and performance are achieved, I would rate it a Buy against this set of ETFs for its high yield and short duration. I will do a follow-up review after one year to see how MTBA treated investors, especially if rates stabilize or head down.