After almost a decade of low interest rates both individual and institutional investors are frustrated by low yields and starving for income. Maturing and called bonds have exacerbated this problem by forcing them to either hold cash or re-invest in lower-yielding issues.
These investors face the unenviable choice of either extending maturities to earn more income, fully aware that even a small increase in interest rates will depress prices and wipe out several years of income; or parking their cash in money market instruments that provide almost no income while continuing to wait for higher interest rates.
Investors buying intermediate- or longer-term issues can reasonably expect interest rates to rise at some point before they reach maturity. As a result they either have to be satisfied with minimal yields for the term of the bond or sell them before interest rates rise, but that requires a forecasting ability that few investors have consistently demonstrated.
A proven way of mitigating the negative impact of rising interest rates is to construct a short-duration portfolio so that when interest rates rise maturing bonds can be re-invested in higher yielding securities and the remaining short-term bonds are shielded from major price declines. Unfortunately, the current yields on high-grade, short-term issues are extremely low and money market issues yield almost nothing.
An improvement on merely having short maturities (two to five years) is to have a laddered portfolio with issues maturing each month so that as interest rates rise there isn’t a one or two year wait to reinvest. However, except for the largest investors, it is impractical to have a portfolio of issues maturing monthly and internally generating cash flow to reinvest as interest rates rise.
The better alternative is for investors to buy U.S. government agency mortgage-backed securities (MBS) that were issued years ago when interest rates were higher. Like other bonds, these higher-coupon issues sell at a premium to par value. And because they are guaranteed by an agency of the U.S. government, credit risk is not an issue. In fact, during the global financial crisis, these issues had no down quarters even though one- to three-year U.S. Treasuries (generally thought of as the “go to” asset to reduce risk) had three negative quarters.
The major risk is that homeowners will refinance and prepay these mortgages and the holders who have paid a premium to capture the higher coupons will receive par for that portion that is repaid. The market generally prices in a substantial yield premium to reflect the refinancing risk. In many cases, however, it is possible to select pools of seasoned mortgages that have far lower-than-average refinancing risk and be paid the premium yield while mitigating the risk.
Most pools of mortgages have had substantial pay downs of principal as homeowners re-financed their home mortgages at successively lower interest rates during the past several years. The remaining mortgages in these seasoned mortgage backed securities are much less likely to refinance. Careful selection criteria are required. Among them are:
• Pools issued four or more years ago. Home owners have had many opportunities to refinance during this period. Those that have not yet done so, and meet the criteria listed below, are less likely to do so now and when interest rates begin to rise.
• Mortgages with low loan to value ratios. Again, these homeowners could have refinanced but have demonstrated that they are not motivated to do so.