A Morningstar Medalist Offering Exposure to Agency MBS

Vanguard Mortgage-Backed Securities ETF VMBS is a great choice for exposure to the agency mortgage-backed securities market. It is tough to beat broadly diversified exposure to this conservative area of the bond market for a rock-bottom fee over the long run, and that is why the strategy earns a Morningstar Analyst Rating of Silver.

The strategy tracks the Bloomberg Barclays U.S. MBS Float Adjusted Index, which includes U.S. agency MBS denominated in U.S. dollars with at least $1 billion outstanding and that have a weighted average maturity of at least one year. The index is market-value-weighted, which mitigates transaction costs and free-rides off the market’s collective wisdom. In this market, it is difficult for active managers to outperform without taking additional risk, given the low credit risk of the issues. The fund’s cost advantage should translate into above-average peer-relative performance over the long term.

The securities in the index are backed by a large pool of mortgages, and the payments made by the borrowers of these mortgages are passed along to investors. This strategy has minimal credit risk, as its holdings are rated AAA. However, the fund contains debt securitized by Fannie Mae, Ginnie Mae, and Freddie Mac, and only bonds issued by Ginnie Mae are backed by the full faith and credit of the U.S. government. But given that Fannie Mae and Freddie Mac have been under the conservatorship of the U.S. government since 2009, the credit risk has largely been removed, while a yield premium relative to Treasuries remains.

As proxied by the ICE Bank of America U.S. Treasury Index and the ICE Bank of America U.S. Mortgage Backed Securities Index, the option-adjusted yield premium for agency MBS averaged approximately 40 basis points during the trailing 10 years through July 2020. While this is less than what was offered prior to the 2008 financial crisis, agency MBS still provide a few key benefits. On top of the additional yield relative to Treasuries, they contain much less credit risk relative to investment-grade corporate bonds, and they are driven by a different risk exposure (which means they provide diversity).

Prepayment risk is the source of the yield premium, and it arises because of the tendency of mortgagors to refinance when interest rates fall. Consequently, they have negative convexity. This means that the duration of the strategy changes when interest rates change, so they don’t respond in the same fashion as bonds with positive convexity.

The strategy should perform well relative to its intermediate government bond Morningstar Category peers during periods when credit risk is rewarded, or when interest rates rise, as prepayments are less likely in those periods. But widening credit spreads or falling interest can act as a headwind to the fund’s category-relative performance, as Treasuries tend to outperform during those times. Nonetheless, the fund’s conservative composition should minimize its downside and mitigate large drawdowns.

People An experienced, well-equipped team manages all of Vanguard's fixed-income index strategies, underpinning the Above Average Pillar rating.

Joshua Barrickman is the named portfolio manager, and has been since 2013, when he was promoted to head Vanguard’s Bond Index Group.

Portfolio management at Vanguard is a team effort, so key-person risk is not a concern. Barrickman leads a team of sector specialists, including a manager focused on government bonds, along with an exchange-traded fund team, which helps with ETF basket creation. These managers are also supported by a team of traders who focus on execution, as well as a data team, which checks incoming index data and helps the managers prepare for upcoming index changes. These teams free up time for the managers to focus on portfolio construction and index tracking. There’s also a separate risk management team that independently monitors the managers’ performance.

Although fund managers are not required to invest in this strategy, Vanguard aligns managers’ incentives with investors’ by tying their compensation and performance evaluation to the strategy’s tracking error.

Process This broad, market-value-weighted portfolio accurately reflects the composition of the U.S. MBS market, harnessing the market's collective wisdom. It also mitigates transaction costs by keeping turnover low and tilting toward the largest bond issues, which tend to be the cheapest to trade. The strategy earns an Above Average Process Pillar rating.

The fund employs representative sampling to track the Bloomberg Barclays U.S. Float Adjusted MBS Index, which includes U.S. agency MBS denominated in U.S. dollars. The securities are issued by Ginnie Mae, which is explicitly backed by the full faith of the U.S. federal government, and Fannie Mae and Freddie Mac, which were put into conservatorship by the U.S. government in response to the 2008 mortgage crisis. The securities include 15-, 20-, and 30-year mortgages.

The holdings of the index are weighted by float-adjusted market value, which excludes amounts held by central banks. This should not have a material affect on the fund’s performance, as the performance of the index and its non-float-adjusted counterpart differed by just 4 basis points over the trailing 10 years through July 2020.

As a market-value weighted index, the largest and most liquid issues carry the most weight. Qualifying issues must have at least $1 billion outstanding and have a weighted average maturity of at least one year. The index is rebalanced monthly.

Portfolio The fund is composed exclusively of securitized debt and a minimal cash balance. As of February 2020, nearly 100% of the fund's portfolio was in AAA rated debt, so the fund does not take much credit risk in absolute terms. Additionally, approximately 25% of the fund's portfolio consisted of debt issued by Ginnie Mae and thus fully backed by the U.S. government.

While the bulk of the fund’s remaining assets were issued by Fannie Mae and Freddie Mac, which are government-sponsored enterprises, these enterprises are under Federal conservatorship.

The intermediate government bond category is composed of funds benchmarked to Treasury and agency MBS indexes, so the fund contains prepayment risk which is not contained in many of its category peers. As a result, the prices of MBS typically don’t rise as much as Treasuries when rates fall, as this tends to increase mortgage refinancing and prepayment.

The fund’s average effective duration as of July 2020 was approximately 3.0 years, in line with the category average. However, it tended to have a slightly shorter duration than the category average over the past five years. The portfolio’s duration is fairly low, despite the fund’s inclusion of 30-year mortgages, largely on account of prepayment risk.

Performance The fund's performance during the trailing 10 years through July 2020 has been solid, reflecting not only its cost advantage but also the fact that agency MBS tend to offer higher yields than Treasury bonds. It beat the category average by 2 basis points annually, which ranked among the category's middle third.

The fund was less volatile than most of its category peers, most likely because of its muted interest-rate risk. It ranked among the category’s least-volatile third over the trailing 10 years through July 2020.

Although they have low credit risk, agency MBS carry slightly more credit risk relative to Treasury bonds, which together with their prepayment risk, tends to give them higher yields. This strategy is likely to outperform Treasury bonds with similar duration during most normal market conditions, when neither interest rates nor credit spreads change dramatically.

But the fund will likely lag category peers during a traditional flight to quality, as money pours into Treasury bonds given their perceived safety. While the strategy held up well during the onset of the novel coronavirus pandemic, gaining 1.95% between Feb. 20 and March 26, 2020, funds in the category with greater exposure to Treasuries fared better. The strategy lagged the category average by 15 basis points.