Dennis' Mortgage Blog

Let's say you are an investment fund manager and your fund is a bond fund.  You invest your investors money and get a fixed return on that money.  Prices come into play, obviously they do on all investments, but primarily you are the "safe haven" for investors who want to shield some of their assets from the volatility of the equity markets. 

Shielding assets is one thing, being defensive and getting a return on your investment is quite another however and this is the challenge for the bond investor, or fund manager, these days.  Or is it?

Everyone knows the basic rule of investing, the greater the risk the greater the return.  So obviously the lower the risk the lower the return.  Cash pays no return, you keep it in your wallet and your risk is your wallet gets stolen.  Your savings account at 1% or less return is minimal risk because the FDIC insures you up to a point. 

What about the U.S. Government? Never defaulted on a loan payment and has the power to print hundred dollar bills to pay your interest every month.  Not a lot of risk, even with the printing presses overheating, because, well we are the United States of America and there is no way we default. Right?  But investing in U.S. Treasury bonds doesn't do much more for you than keeping your money in your wallet or bank account. 

Today a 1 year Treasury bill has a yield of 0.27%, if you buy $100,000 in 1 Year t-bills you will be paid back 100,270.  Not enough to buy a really good sport coat.  The ten year bond will pay you 3.46%, almost $3500 but you have to wait ten years to get it.  Too little return even with no risk.

What about state and municipal bonds? Well some are paying better than the Treasury that is for sure, and you can buy used bonds for pretty cheap because folks like AIG and All State are dumping their holdings.  What are you investing in?  A state with a structural deficit of 20% and political turmoil that prevents long term solutions?  A city or county with similar woes and a chance to file bankruptcy before the new water and gas infrastructure that is being financed can be completed?  Too much risk for too little return.

What about mortgages? Mortgage Backed Securities (MBS) have had some disappointments in recent years with the foreclosure rates still climbing in some areas, but vast majority of those loans were made prior to 2008.  Even with the Fed no longer purchasing MBS, in fact now selling off its portfolio of approximatel7 $165 billion, MBS yields have held fairly steady.  What about MBS as a risk-reward venture?

This is a question that many fund managers and large investors have been answering in the affirmative of late.  With backing of Fannie Mae and Freddie Mac from the Treasury the risk is greatly diminished for investors.  As well, due to tighter underwriting standards throughout the industry and the elimination of Fannie and Freddie's stated income and stated asset policies for many mortgages the quality of borrowers has risen considerably. 

Because of the lack of alternatives for security and safe havens plus decent yields, MBS have become popular with investors.  As a result mortgage rates, while moving a bit here and there have remained pretty consistent for the past several months and borrowers have benefited. 

Seeing no reason why the dynamic of yields and risk should change anytime soon, look for mortgage rates to continue to remain relatively low as long as inflation remains below 1.75-2.00%.  With this economy and investment cycle Mortgage Backed Securities appear to be the fairest bond of all.