The Bond ETF Most Investors Overlook -- and Why It Belongs in Your Portfolio Right Now

Bonds play an important role in helping investors diversify their portfolios. One of the easiest ways to add bonds to your portfolio is through an exchange-traded fund (ETF).

Most investors likely invest in bond ETFs focused on U.S. treasuries or investment-grade corporate bonds. There's nothing wrong with that as they're high-quality fixed-income investments. However, it causes many investors to overlook the combination of quality and yield offered by mortgage-backed securities (MBS). One of the best ways to invest in these bonds is the Vanguard Mortgage-Backed Securities ETF (NASDAQ: VMBS). Here's why it belongs in your portfolio right now.

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The other bonds

MBS are collections of mortgages bundled by a bank or financial institution and sold to government-sponsored agencies (GSAs: Ginnie Mae, Fannie Mae, and Freddie Mac). The GSAs guarantee these loans against credit losses and sell them to investors, including mortgage REITs and ETFs. That gives Agency MBS a risk profile similar to that of U.S. Treasuries. Because the U.S. government backs these bonds, they carry near-zero default risk, as it can raise taxes or print money to satisfy its debt obligations.

However, while MBS have a similar risk profile to treasuries, they typically yield higher, often closer to investment-grade corporate bonds. While investment-grade corporate bonds also have low default risk, they're still riskier than treasuries.

Given their treasury-like risk profiles and yields similar to those of investment-grade corporate bonds, MBS offer investors the best of both worlds.

The easy way to invest in MBS

The Vanguard Mortgage-Backed Securities ETF aims to provide investors with a moderate and sustainable level of current interest income. It does that by investing in Agency MBS. The fund currently holds 1,435 MBS issued by GSAs. It invests in MBS with an average maturity of three to 10 years, leaving it with moderate interest rate risk. The ETF's holdings currently have an average effective maturity of 6.7 years and a yield to maturity of 5%.

That already attractive yield could rise in the future. Heading into this year, most bond investors expected mortgage interest rates to continue falling as the Federal Reserve kept cutting rates. However, that hasn't happened as inflation has reaccelerated due to the impact the war with Iran has had on energy prices. As a result, yields on newly issued MBS are around 6.5% this year, up from the sub-6% rate investors initially expected. That's allowing VMBS to roll maturing lower-yielding MBS investments into higher-yielding ones, which should boost its yield going forward.

A low-risk, higher-yielding bond investment

MBS offer investors the best characteristics of U.S. Treasuries (low risk) and investment-grade corporate bonds (higher yields). Despite those features, most investors overlook these bonds because they aren't very familiar with how to invest in them. The Vanguard Mortgage-Backed Securities ETF makes it easy to invest in these low-risk, higher-yielding bonds. With its already attractive yield likely to rise, it belongs in your fixed-income portfolio right now.

Matt DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.