MBS ETFs and the Case for SMBS in a Rising Rate Environment: A Strategic Play for Fixed Income Portfolios

In the ever-shifting landscape of fixed income investing, mortgage-backed securities (MBS) ETFs have carved out a unique niche—particularly in rising rate environments. As the Federal Reserve's 2024–2025 tightening cycle has pushed mortgage rates above 6%, investors are reevaluating their fixed income allocations. While traditional bond ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG) have underperformed, MBS-focused funds such as the iShares MBS ETF (MBB) and the Schwab Mortgage-Backed Securities ETF (SMBS) have demonstrated resilience. This article unpacks why MBS ETFs, and SMBS in particular, offer compelling advantages in terms of cost efficiency, diversification, and strategic positioning for portfolios navigating a higher-rate world.

Cost Efficiency: The ETF Edge in a Complex Market

MBS ETFs inherently reduce transaction costs and enhance liquidity compared to direct ownership of individual mortgage-backed securities. The secondary market for ETFs allows investors to trade shares at real-time prices, avoiding the high bid-ask spreads and execution risks of over-the-counter MBS. For example, the average bid-ask spread for MBB has narrowed to 0.25 basis points in 2025, a stark contrast to the 10–15 basis point spreads typical for individual agency MBS.

Moreover, MBS ETFs offer tax efficiency. Unlike mutual funds, which distribute capital gains from internal trading, ETFs minimize taxable events by enabling in-kind redemptions. This is critical in a rising rate environment, where frequent price swings in MBS can trigger capital gains in less efficient structures. The Schwab Mortgage-Backed Securities ETF (SMBS), for instance, has recorded zero capital gains distributions since its 2022 launch, a testament to its tax-optimized design.

Diversification: A Ballast for Volatile Markets

One of the most underrated benefits of MBS ETFs is their defensive role in equity-heavy portfolios. Agency MBS—backed by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac—have historically outperformed corporate bonds during equity market selloffs. From 2020 to 2025, the Bloomberg U.S. MBS Index has outperformed the Bloomberg U.S. Corporate High Yield Index in six of the last seven major equity corrections. This is due to two factors:

1. High credit quality: Agency MBS are effectively risk-free in terms of default, as GSEs guarantee principal and interest payments.
2. Negative convexity: While this characteristic (where prices fall more sharply when rates rise) is often cited as a drawback, it also creates a stabilizing effect. In a rising rate environment, MBS ETFs extend their duration, locking in yields and acting as a buffer against broader bond market losses.

SMBS, with its 98% allocation to agency MBS, exemplifies this. Its 2025 yield to worst of 5.4%—nearly 100 basis points above the 10-year Treasury—positions it as a high-conviction income play.

Strategic Positioning: Navigating the Fed's Tightening Cycle

The Federal Reserve's 2024–2025 tightening cycle has created a mispricing in the MBS market. As the Fed unwinds its balance sheet (quantitative tightening), the supply of MBS has dwindled, pushing spreads wider relative to corporate bonds. This has created an opportunity for active managers to capitalize on relative value arbitrage.

Take SMBS's 104-basis-point spread over the 7-year Treasury. By historical standards, this is a narrow spread, suggesting MBS are undervalued. With the Fed expected to begin rate cuts in 2025, the yield curve is likely to steepen, boosting the price of longer-duration MBS. SMBS's 5.44-year modified duration means it will benefit from this steepening, offering both income and capital appreciation.

The Case for SMBS: A Sharper MBS Play

While MBB and VMBS remain popular, SMBS has emerged as a more focused and cost-effective option. With an expense ratio of 0.15% (compared to MBB's 0.18%), SMBS offers a slight edge in net returns. Its smaller size ($4.5 billion in assets under management as of July 2025) also allows for more agile portfolio management, which is critical in a market where prepayment risk (once a major concern) is now near-historic lows.

With 70% of U.S. mortgages originated at sub-5% rates in 2020–2021, refinancing activity has ground to a halt. This has eliminated the “negative convexity” risk that once plagued MBS ETFs. As a result, SMBS's cash flows are more predictable, reducing reinvestment risk and enhancing its appeal to income-focused investors.

Conclusion: A Strategic Allocation in a New Rate Regime

MBS ETFs are no longer a niche play. In a rising rate environment, they offer a compelling combination of cost efficiency, diversification, and strategic positioning. For investors seeking income, capital preservation, and downside protection, SMBS and its peers provide a bridge between traditional bonds and equities.

Investment Advice:
- Core Allocation: Allocate 5–10% of fixed income portfolios to MBS ETFs like SMBS for yield and diversification.
- Tactical Overweights: Consider increasing exposure to MBS ETFs as the Fed's rate cuts begin, given the expected steepening of the yield curve.
- Active Management: Favor active MBS ETFs (like SMBS) over passive alternatives to capitalize on relative value opportunities in a fragmented market.

As the fixed income ETF market approaches $6 trillion in assets by 2030, MBS ETFs are poised to play a central role in modern portfolios. For those willing to embrace the nuances of mortgage-backed securities, the rewards could be substantial.