Move over TINA, it’s TARA time. The latter means “there is a reasonable alternative,” a reference to the bonds I heard about in the financial media last week. This is of course the opposite of the acronym for “There is no alternative” to actions, which has rather worn after the
12.76% negative return in the first five months of 2022.
Although the acronym TARA did not originate here, it should be familiar to readers of this space. In mid-April, this column noted that the sharp rise in bond yields this year had made the relative valuation of stocks less attractive. Moreover, the even steeper rise in municipal bond yields after a “breathtaking” drop in their prices has made their after-tax yields particularly attractive.
Similarly, this column pointed out last month that short- and medium-term yields had climbed in anticipation of further hikes in the Federal Reserve’s fed funds target. Funds investing in these maturities have provided almost as much (or, in some cases, more) return than their longer-term counterparts, and with a fraction of the risk.
TARA fans should now consider the Ginnie Mae, Fannie Mae and Freddie Mac paper. They issue agency mortgage-backed securities that are now “crazy cheap,” writes Harley Bassman, a former head of mortgage operations at Merrill Lynch, who currently works at Simplify Asset Management. These “vanilla MBS” are attractive, he adds, relative to their Treasury and corporate bond counterparts.
In his latest Convexity Maven blog post, Bassman explains that the spread – the supply of extra-yielding mortgage-backed securities over Treasuries – had climbed to 125 basis points, from a low of 50 when the Fed announced 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. For those who have reviewed the stats, that’s a lot of extra yield.
Since their government guarantee effectively makes these agency MBS as safe as treasury bills, the spread reflects the option embedded in a mortgage-backed security. While most readers might think of options primarily as speculative bets on stocks, they are an integral part of many fixed income securities.
Mortgage-backed securities loans offer mortgage borrowers the flexibility to prepay when it suits them. Prepayments typically occur when mortgage rates fall, providing an opportunity to refinance at lower cost, cash out some of the increased equity from house price appreciation, or swap for another home. Life events, such as a job change, divorce, or aging, can also cause homeowners to prepay their loans regardless of rate changes.
Investors in mortgage-backed securities effectively sold a covered call option on their holdings, with the options premium representing their extra yield over risk-free Treasury bills. This is not unique to mortgages; most munis are redeemable for 10 years from their initial issue. For high-coupon munis – say, those paying more than 5% – these call options are deep in the money, making their exercise almost certain once the call protection ends. Convertible securities are the other side of the coin; the investor holds a call option on the shares of the issuer, in addition to the bond.
As the bond market sold off earlier this year, mortgage-backed option premiums widened, driven by higher bond volatility as measured by the MOVE Index, the bond corollary of the
Cboe Volatility Index,
or VIX, for stocks (and which happens to have been invented by Bassman).
He recommends moving from Treasuries and corporates to MBS to take advantage of the latter’s attractive relative valuation. As with almost everything else these days, there are exchange-traded funds for that:
(symbol: MBB) and Vanguard Mortgage-Backed Securities (VMBS).
Unlike previous cycles, most of the MBS market presents little prepayment risk, given all the 3% mortgages that were taken before the rate spike and that homeowners will cling to now that rates are greater than 5%. Once big fund managers realize they can buy a credit risk-free bond with a “huge” spread over Treasuries, the MBS yield spread should narrow, leading to significant outperformance. , Bassman wrote in an email.
A more speculative alternative would be real estate investment trusts that invest in mortgage-backed securities. One is
(AGNC). It invests in agency MBS and uses leverage to increase its dividend to 11.83%. This kind of return comes with significant risk, as evidenced by the equities’ plunge to around $12 from over $15 year-to-date due to the bond market’s sell-off.
Bassman prefers mREITs that use mortgage servicing rights, which may actually benefit from rising mortgage rates. An example: the
PennyMac Mortgage Investment Trust
(PMT), which offers a dividend yield of 11.55%. It has not been immune to the hit to mREITs this year, recently trading at $16, down from over $18 at the start of the year.
Bottom line: For new TARA fans, vanilla MBS offer above-average yield over their Treasury counterparts with less credit risk than comparable companies.
Write to Randall W. Forsyth at firstname.lastname@example.org