Mortgage-backed securities ETFs are facing their biggest investor exodus since the pandemic as surging Treasury yields and elevated interest-rate volatility make mortgage bonds less attractive relative to government debt.

MBS ETFs See Heaviest Selling Since 2020

U.S. mortgage-bond ETFs recorded $2.4 billion in net outflows in September, the largest monthly withdrawal since March 2020, according to Bloomberg.

The selling was concentrated in major MBS funds. The iShares MBS ETF (NASDAQ:MBB) lost about $2.7 billion during the month, its largest monthly outflow since launch. MBB also fell roughly 3% on a total-return basis, compared with a 2.4% decline for a broad U.S. bond-market ETF.

The Simplify MBS ETF (NYSE:MTBA) and Schwab Mortgage-Backed Securities ETF (NYSE:SMBS) also posted record outflows of approximately $342 million and $245.8 million, respectively.

Why Rising Rates Hurt Mortgage Bonds

The pressure goes beyond the typical price decline caused by rising yields.

Mortgage-backed securities carry significant prepayment and duration risk. When interest rates rise, homeowners have less incentive to refinance, meaning mortgages can remain outstanding for longer. That effectively extends the duration of MBS just as bond yields are climbing.

Meanwhile, sharp and unexpected rate moves make it harder for investors to predict when borrowers will refinance.

That matters even more when Treasury yields move above 5%. Investors can earn relatively high yields from government debt without taking on the additional prepayment risks associated with MBS.

Investors May Be Rotating, Not Abandoning MBS

The ETF flows also reveal an important shift within the mortgage-bond market.

BlackRock's model allocation team sold more than $1 billion of passive MBB in September while moving into its actively managed MBS ETF, which attracted about $560 million, Bloomberg reported.

That suggests some investors may still want mortgage exposure but prefer active management to navigate rate volatility and changing prepayment behavior.

Other dedicated MBS ETFs include the SPDR Portfolio Mortgage Backed Bond ETF (NYSE:SPMB) and Vanguard Mortgage-Backed Securities ETF (NASDAQ:VMBS).

Why ETF Investors Should Watch MBS Flows

MBS demand has broader implications because mortgage bonds are closely linked to housing finance. Sustained selling could contribute to wider mortgage spreads and higher borrowing costs.

For investors, it is important to keep an eye on whether the September exodus represents a temporary response to rising Treasury yields, or a more lasting shift away from passive MBS exposure as 5% Treasury yields reset the income trade-off.