Are you tired of the rising cost of housing and high mortgage rates, the low supply of homes and the fierce bidding wars that are now a necessity to find a decent place to live?
If you want revenge, buy mortgage-backed securities.
No, investing in these lesser-known financial products won’t directly reduce your high housing costs, but it will allow you to profit from housing investment opportunities that remain hidden by bond experts sticking to the Federal Reserve.
I mostly write about stocks, but a bargain is a bargain, and if you’re looking to generate cash flow in retirement or simply want lower volatility, a mix of bonds and stocks can help.
And yes, you can buy government bonds: long-term ones if interest rates are falling, or short-term ones if you expect rates to rise, or corporate bonds if you want higher yields and a link to economic growth, or high-yield corporate bonds (so-called “junk” bonds) if you want stock-like returns from time to time.
But if you want to really impress your friends and family, consider mortgage-backed securities. Mortgage-backed securities have gotten a bad rap because of lower-quality versions that played a starring role in the 2008 financial crisis. But not these. Rather, look at mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac. After the 2008 bailout, these bonds are guaranteed by the U.S. government. Treasury-like quality. So where’s the opportunity?
Typically, agency MBS behave like Treasury’s poor cousins: When Treasury prices rise, prices of agency MBS of similar maturities usually don’t rise as much; when Treasuries fall, MBS usually fall more than they do (in trading jargon, this is called “negative convexity” — google it, it’s hilarious).
Why? Because historically, people have paid off their loans early by moving or refinancing.
Not now. Everything that frustrates you about housing today creates a sweet spot for government-backed MBS. With frustrating 7% mortgage rates, few people refinance. Why would they refinance? Most homeowners enjoyed the old interest rates that were much lower than they are today. This is great for MBS. It means less pushing and pulling in MBS yields with refinancing.
Bond prices and yields move in opposite directions. When long-term interest rates fall, existing high-yield bonds look more attractive, so their prices rise further. All the talk right now about Fed rate cuts is about short-term interest rates. Long-term interest rates are determined by the free market; any topic that is widely discussed in the market is priced in advance. Long-term bond yields will not fall much as a result of a Fed rate cut, because the cut is already expected.
Mortgage rates are historically quite high relative to Treasury yields. However, this will not last. A favorable condition for mortgage rates is near the 20- or 30-year Treasury yield. However, simple volatility has caused rates to rise recently. If this situation were to reverse, and long-term interest rates declined somewhat and bond prices rose, agency MBS prices should rise further, increasing total returns.
How do we implement this? Simple: ETFs.
VMBS and SPMB are two of several tickers that fit well with the requirements of agency MBS: they can be traded instantly with minimal (or no) cost.
Are you tempted to invest in individual bonds yourself? Don’t. Bond markups and embedded transaction costs can be astronomical for retail investors. Individual MBS are not easy to buy or sell in small amounts. Liquidity can worsen as they age, increasing the principal repayments on the underlying mortgages. You could end up with too small a position to sell.
Properly managing agency MBS directly would require frequent rebalancing to reinvest the returned principal, which would increase trading costs and lead to poor pricing. The broker would eat up a lot of your revenue.
ETFs solve all of this. They buy and sell just like institutions do, giving you access to better pricing and much lower transaction costs. Of course, check the prospectus. But they generally keep fees very low and give you more returns. They also maintain diversification and a variety of maturity periods. You’re not overly invested in either the long or short term (which will concentrate risk and make you miss out on opportunities). It’s balanced.
Yes, high mortgage rates frustrate potential homebuyers, but there’s opportunity hiding beneath the uncertainty.
