Inflation and Rising Interest Rates: Short Duration MBS Can Be a Safe Harbor

The Fed raises interest rates and cuts cash. What is the safe harbor for your wallet?

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The Federal Reserve (Fed). They raise interest rates and withdraw cash. This created a difficult environment for stock and bond prices.

To stimulate a Covid-devastated economy, the Federal Reserve added massive amounts of liquidity. They achieved this by keeping overnight interest rates close to zero. And by buying $120 billion in mortgage-backed securities (MBS) and Treasury bonds every month. These programs, in addition to huge government stimulus measures, have flooded the economy with cash. This was needed in March 2020. Now the Fed has admitted that its stimulus measures are fueling inflation. I believe all this liquidity has inflated the price of assets like stocks and bonds.

To slow inflation, the Fed is now considering removing its stimulus measures. The Fed plans to raise overnight interest rates at least four times this year (from zero to over 1.00%) and to continue raising rates next year. Additionally, the Fed plans to end its $120 billion per month purchase program of MBS and Treasuries (by March). And to start reducing their holdings of over $8 trillion in Treasuries and MBS (draining cash from the economy). These plans explain why interest rates have risen dramatically. In response, stocks, municipal bonds and many other assets lost value. And volatility has increased as investors seek appropriate valuations in a period of higher interest rates and lower liquidity.

Where can you find a safe haven in a bear market? Money market accounts? CD? For most people, a separately managed account (SMA) from a short-term government agency securities backed by mortgages may be a much better alternative.

Stocks have always been a great long-term investment. Yet, what do you do with money that you don’t want exposed to stock market volatility?

Money market accounts and CDs are certainly safe. But their yields stink. They make sense if immediate liquidity is your priority. But, if you don’t need immediate cash, why hold assets that yield so little? Municipal bonds and most bond ETFs aim for higher yields, but they come with credit and interest rate risk, a big loser in recent months. A high-quality, short-term Government Agency MBS SMA can target a return of 2.00% to 3.00%, while maintaining a high level of security and stability as well as reasonable liquidity.

It is crucial that the SMA is managed by someone who specializes in MBS. Additionally, an MBS expert in a smaller store can often capture more alpha. It totally works. It’s a hidden gem. I say. This has been my firm’s specialty for 25 years. We are experts in this strategy.

What about high-quality bond funds or ETFs? They advertise higher returns. But they usually carry a much higher risk. In general, I don’t think investors are paid enough to take on additional risk. I think an MBS SMA is a better choice for most investors.

Bond mutual funds or ETFs may seem like a good safe haven. Unfortunately, they generally use bonds with longer maturities and lower credit ratings. During periods of rising interest rates, longer-maturity bonds mean more losses in your portfolio. In times of economic downturn or panicked markets, weaker credits mean more losses in your portfolio. When interest rates rise or credit spreads rise (both are happening right now), investors lose money. Most bond funds have lost money over the past year. And January and February were horrible. I think a separately managed account using medium-short maturity mortgage-backed securities, which can now target a yield of 2.00% to 3.00%, is a much more compelling safe harbor.

Let’s look at some specific examples of popular bond funds. Returns are until February 11, 2022.

Vanguard Total Bond Market (BND is an ETF, VBTLX is a mutual fund). Combined assets $200 billion. Average duration 6.9 years.

YTD return -2.91%. Yield over one year -5.44%

iShares Core US Aggregate Bond ETF (AGG). Assets of approximately $90 billion. Average duration 6.7 years.

YTD return -2.82%. Yield over one year -5.11%

PIMCO Corporate & Income Opportunity Fund (PTY). Assets of approximately $2 billion. Average maturity 9.7 years.

YTD return -8.16%. Yield over one year -14.24%

Annaly Capital Management (NLY). Market capitalization of approximately $11 billion.

YTD return -8.33%. Yield over one year -13.80%

Are the funds above what you want for a safe haven in a bear market? Are the returns above acceptable for the safe side of your portfolio? An MBS SMA with an average maturity of 2.0 years is much less exposed to rising interest rates than the funds above that use bonds with much longer maturities. This is why these short-lived MBS SMAs have been relatively stable in this rising rate environment. As an added benefit, the extremely high credit quality of the government agency MBS provides additional stability compared to bond funds (as above) which include lower rated bonds. I think an MBS SMA, now targeting a 2.00% to 3.00% return, is a much more compelling safe harbor.

What can really make an MBS SMA compelling is that a small store MBS expert has the potential to generate returns equal to or greater than the returns provided by most bond funds that use longer maturities (like those described above). For me, it’s compelling. It totally works. It’s not speculation. I say. I’ve been doing this for clients for over 25 years.

MBS are of very high quality. This supports security, stability and being a safe haven.

The MBS we suggest are issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae – all government sponsored entities. I believe this guarantee greatly reduces or even eliminates credit risk. These MBS tend to perform well in the toughest markets as they did during the Covid crisis of early 2020. And over the past year.

An MBS SMA with an average maturity of around two years can currently target a return of 2.00% to 3.00%. Short maturities should help the portfolio avoid losses, even when interest rates rise. I think these SMAs are a great choice for a safe harbor.

It is essential that the account managed separately from mortgage-backed securities is expertly managed. Small advisors can be more opportunistic.

Alas, finding that expert can be the hardest part of implementing this strategy. An MBS expert at a smaller company can often be more opportunistic than a larger manager and capture more of the alpha we’ve been talking about. Consider this illustration. Imagine that you are looking to buy a used car. You can go to a car dealership and pay retail. What if, as an alternative, you could pay an expert a small fee to buy the car for you at a used car auction at a considerably lower price. As a bonus, the adjuster can better assess the risks associated with owning this car.

In a department store, like Fidelity (NYSE: FNF), you pay the full retail price for the MBS. Like going to the car dealership. In my company and, I imagine, in other smaller stores, we generally buy bonds for our customers at auction. This can often provide 50 to 100 basis points (0.50% to 1.00%) of additional return. In addition, an MBS expert can carefully assess and manage interest rate risk. In summary, I believe that an MBS expert in a small store can get more return for customers with less risk. It totally works. This strategy has been the specialty of my firm for 25 years.

Conclusion

Under the right manager, a high-quality, short-term MBS SMA has the potential to be an excellent safe haven in all markets, including today’s turbulent markets. And can currently target an attractive yield of 2.00% to 3.00%. As a bonus, an MBS segregated account can have much lower risk and volatility than most bond ETFs or mutual funds targeting a similar return.

For more details and a discussion of how an MBS SMA could benefit your overall asset allocation, please see my recent articles:

Generate more income and maintain security with mortgage-backed securities

Hedge against inflation and earn stable income with mortgage-backed securities

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