ETFtrends.com — ETF Trends — Mon Dec 01, 9:00AM CST

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Investors can diversify a fixed-income portfolio with high-quality mortgage-backed securities and related exchange traded funds, but they should also understand the potential risks ahead.

For instance, the Vanguard Mortgage-Backed Securities Index ETF (NYSEArca: VMBS ) tracks a group of investment-grade, high-quality mortgage-backed securities issued by U.S. mortgage agencies, like Ginnie Mae, Freddie Mac and Fannie Mae. [Government Bond ETFs Remain The Safer Play ]

“As of October 2014, Agency MBS represented 20.7% of the Barclays U.S. Aggregate Bond Index. Because of their large representation within the benchmark, MBS may be used as a tactical investment when investors think mortgages are cheap relative to Treasuries and corporate bonds,” according to Morningstar analyst Thomas Boccellari.

Mortgage-backed securities are crafted through by combining variety of different individual mortgages into one security. If a bank or lender does not want to hold a loan on its balance sheets, it may decide to sell to one of the U.S. agencies to monetize the asset. In turn, the agency would combine the mortgages to create a mortgage-backed security and pay out interest and principal payments from the underlying assets to investors.

On the yield scale, investors can typically expect mortgage-backed securities to pay more interest than similar maturity Treasuries but less than similar maturity corporate debt. VMBS has a 4.3 year effective duration and a 1.35% 30-day SEC yield.

However, there are some particularly specific risks associated with the asset class. For instance, borrowers can prepay mortgages, which poses a large risk in a falling rate environment since borrowers would typically refinance their mortgages at cheaper rates. Consequently, mortgage-backed securities investors would get their principal back before maturity and have to reinvest at the lower rates.

“Because mortgages can be refinanced, they have call risk – the risk that borrowers refinance their mortgages,” Boccellari added. “While years of falling and low interest rates led to increased refinancing of existing mortgages, refinancing activity has slowed considerably over the past two years.”

Currently, the refinancing rate is closer to its 10-year trailing average, and refinancing risk seems minimal since most who can refinance at lower rates have already done so.

On the other hand, in a rising rate environment, mortgage-backed securities have so-called extension risk where capital is invested at low rates for an extended period where there is a high likelihood of rising rates down the line, which make existing securities less attractive than newer issues. [ETFs for a Changing Bond Market ]

Alternatively, the iShares MBS ETF (NYSEArca: MBB ) is the largest MBS ETF on the market. The iShares options is similar to VMBS, except MBB includes mortgage securities from the Federal Reserve. VMBS is also cheaper with a 0.12% expense ratio, comapred to MBB’s 0.27% expense ratio. MBB has a 4.33 year effective duration and a 1.62% 30-day SEC yield.

Additionally, the SPDR Barclays Mortgage Backed Bond ETF (NYSEArca: MBG ) tracks a similar index of mortgage securities and comes with a 0.29% expense ratio, 4.52 year duration and a 2.24% 30-day SEC yield.

For more information on the fixed-income market, visit our bond ETFs category .

Max Chen contributed to this article .

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.