Rising mortgage rates, alternate AAA fixed income investments

The Federal Reserve influences mortgage rates by setting the fed funds (short-term) rate but also by Quantitative Easing (buying mortgage-backed bonds in the market). When the Fed raised the fed funds rate and also started Quantitative Tightening (QT) by sellling mortgage-backed bonds, mortgage rates rose rapidly. The 30-year fixed-rate mortgage is now over 7%. As a result, the housing bubble stopped in its tracks. Housing prices are beginning to drop.

But there’s more to the story.

Mortgage Rates Are High Because Nobody Is Buying Mortgages

Banks went on a mortgage-bond buying spree last year, but now they are stepping back from the market

By Ben Eisen, The Wall Street Journal, Nov. 15, 2022


Banks have stepped back from buying mortgage bonds. So has the Federal Reserve, the largest investor in that market. Foreign buyers and money managers are curtailing purchases too, analysts say. The lack of buyers has helped push mortgage rates to their highest level in 20 years. …

Today, a shrunken pool of buyers are demanding a higher yield to own mortgage bonds. That is driving up the rates on the mortgages inside those bonds at a faster pace than their benchmark, Treasury yields. The gap between them was recently the biggest since the 1980s, according to the Urban Institute…“Banks stepping back, the Fed stepping back, foreign investors stepping back—that has widened the spread that mortgages trade at versus Treasurys, which directly translates to the borrower’s mortgage rate…” [end quote]

High mortgage rates make housing unaffordable for many home buyers. Private equity groups are buying homes for cash, shutting out many potential family buyers and forcing them into rentals which are seeing rapid inflation.

From a fixed income investor’s standpoint, the widening spread between the mortgage-backed bonds and Treasuries represent an opportunity. Currently, here are some fixed income options. (All numbers from Fidelity and Treasury Direct.) Bank CDs from Fidelity are yielding higher than the identical CDs from the bank – can’t understand why. The shopping list at Fidelity changes continuously as bonds are bought and sold from brokers.

Money market funds yielding 3.3%

Bank CDs, secondary market, 5 year, 4.5% - 5%

Mortgage-backed securities (AAA), 5 year, 4.5% - 5.5% (many are callable so if interest rates drop they could be called away)

TIPS, 5 year, 2% + inflation, fixed coupon

I-Bonds, 6.89% (0% + inflation).

All the above can be sold before maturity on the secondary market, where the value will drop if interest rates rise…

EXCEPT the I-Bond, which cannot be sold on the secondary market and always returns full principal regardless of prevailing rates. After 1 year, an I-Bond is essentially as liquid as inflation-adjusted cash except 3 months of interest will be subtracted if redeemed under 5 years.

The interest from TIPS and I-Bond are exempt from state and local tax.

These are all AAA rated.
Wendy (cross-posted to METAR)

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I think it’s 0.4% + inflation now.

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Thanks, you are correct.
https://treasurydirect.gov/savings-bonds/i-bonds/i-bonds-interest-rates/
Wendy

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It seems like when interest rates were super low, the wise investment would have been inverse bond funds. I haven’t checked but I bet now that the fed is raising interest rates, those funds are going crazy. Any thoughts on this? Thanks…doc

Sounds logical. However when interest rates were super low was a pretty long span of time. If we take 4% as a cut off point, from June of 2019 through February of 2022 they stayed below that. 34 months. At the end of that period reverse bonds would, as stated, have done well. Earlier? Not really.

I would have worked on accumulating these bond funds during the 34 months and cost averaged purchases at the lower end, then rode out the ride up - just saying. We have no idea yet when the fed will stop raising interest rates at this time…doc

If you are considering such a fund, please read the prospectus very carefully. These funds are meant as short-term speculation, not a long-term buy and hold. Small daily fluctuations, like last week’s fall in the 10 year Treasury bond yield, can cause a rapid fall in the NAV of an inverse bond fund which is hard to recover.

I tried an inverse bond fund a long time ago in a similar situation – where I was confident that yields would rise – and got burned. Never again. I’m a risk-averse long-term investor. Currently I am buying short-duration secondary-market bonds but planning to go long duration next year.
Wendy

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I mentioned this in another thread, but there was no discussion about it. Ironically, all of us folks that hurried to buy I-bonds at the historically high rate last period will end up with a lower overall yield than folks who procrastinated and bought in this period instead.

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