Bonds from Ginnie Mae, Fannie Mae, and Freddie Mac are more attractive than Treasuries or corporates.
David Paul Morris/Bloomberg
Move over TINA, it’s time for TARA. The latter stands for “There’s a Reasonable Alternative,” a reference to bonds I heard bandied about in the financial media this past week. That, of course, is the opposite of the acronym for “There Is No Alternative” to stocks, which has gotten rather shopworn after the S&P 500’s 12.76% negative return in 2022’s first five months.
While the TARA acronym didn’t originate here, it should be familiar to readers of this space. Back in mid-April, this column noted that the sharp rise in bond yields this year had made the relative valuation of equities less attractive. Moreover, the even more pronounced jump in municipal bond yields after a “breathtaking” fall in their prices made their after-tax returns especially attractive.
Similarly, this column pointed out last month, short-to-intermediate-term yields had shot up in anticipation of additional hikes in the Federal Reserve’s federal-funds target. Funds investing in those maturities provided nearly as much (or, in some cases, more) yield than their longer-term counterparts, and with a fraction of the risk.
Fans of TARA now should consider paper from Ginnie Mae, Fannie Mae, and Freddie Mac. They issue agency mortgage-backed securities that now are “crazy cheap,” writes Harley Bassman, a former head of mortgage operations at Merrill Lynch who’s currently with Simplify Asset Management. These “vanilla MBS” are attractive, he adds, relative to their Treasury and corporate fixed-income counterparts.
In his latest Convexity Maven blog post, Bassman explains that the spread—the extra yield mortgage-backed securities offer over Treasuries—had surged as high as 125 basis points, from a low of 50 when the Fed said last year that it would stop buying MBS. (A basis point is 1/100th of a percentage point.) The recent spread of 110 basis points is two standard deviations above the long-term historical average, which would put the MBS around 4% versus Treasury notes trading Friday at 2.93%. For those who snoozed through statistics, that’s a lot of extra yield.
Given that their government guarantee effectively makes these agency MBS as safe as Treasuries, the spread reflects the embedded option in a mortgage security. While most readers might think of options mainly as speculative bets on stocks, they are integral parts of many fixed-income securities.
The loans linked to mortgage-backed securities provide home borrowers the option to prepay whenever it suits them. Prepayments usually occur when mortgage rates drop, offering the opportunity to refinance at a lower cost, to cash out some of the increased equity from house-price appreciation, or to trade up to another abode. Life events, such as a job change, divorce, or aging, also can also induce homeowners to prepay their loans, independent of rate changes.
Investors in mortgage-backed securities have effectively sold a covered-call option on their holdings, with the options premium representing their extra yield over risk-free Treasuries. This isn’t unique to mortgages; most munis are callable 10 years from their original issuance. For high-coupon munis—say, those paying upward of 5%—those call options are deep in the money, making their exercise nearly certain once the call protection ends. Convertible securities represent the flip side; the investor owns a call option on the issuer’s stock, in addition to the bond.
As the bond market sold off earlier this year, the options premiums on mortgage-backeds widened, owing to the rise in bond volatility as measured by the MOVE index, the bond corollary to the Cboe Volatility Index, or VIX, for stocks (and which happened to have been invented by Bassman).
He recommends switching from Treasury and corporate securities to MBS to take advantage of the latter’s attractive relative valuation. As with nearly everything else these days, there are exchange-traded funds for that: iShares MBS (ticker: MBB) and Vanguard Mortgage-Backed Securities (VMBS).
Unlike as in past cycles, most of the MBS market has little prepayment risk, given all the 3%-ish mortgages that were taken out before rates shot up that homeowners will hang on to now that rates are over 5%. Once big money managers realize that they can buy a bond with no credit risk at a “huge” spread over Treasuries, MBS’ yield differential should narrow, resulting in significant outperformance, Bassman writes in an email.
A more-speculative alternative would be real estate investment trusts that invest in mortgage-backed securities. One is Agnc Investment (AGNC). It invests in agency MBS and uses leverage to boost its dividend to 11.83%. That kind of yield brings significant risk, evident from the shares’ drop to around $12 from over $15 since the turn of the year as a result of the bond market’s selloff.
Bassman prefers mREITs that use mortgage servicing rights, which actually can benefit from rising mortgage rates. One example: the PennyMac Mortgage Investment Trust (PMT), which offers an 11.55% dividend yield. It hasn’t been immune from the hit to mREITs this year, trading in the low $16s recently, down from above $18 early in the year.
Bottom line: For TARA’s newfound fans, vanilla MBS offer a greater-than-usual fillip of yield over their Treasury counterparts with less credit risk than comparable corporates.
Write to Randall W. Forsyth at [email protected]
