Protect against inflation and earn stable income with mortgage-backed securities

1.Stocks are a great investment. But how do you generate income on the money you want to keep safe?

2. Rather than earning nothing in money market funds and CDs, target 1.50% to 2.50% with super safe mortgage-backed securities.

3. What about higher risk bond funds and bond alternatives? Mortgage-backed securities may offer better risk-adjusted returns. You may be better off taking the extra risk in stocks.

4. When managed by an expert, a separately managed account (SMA) of safe mortgage-backed securities (MBS) may be a great source of stable income – and help improve overall portfolio performance.

For those of you not familiar, we want to define two acronyms used throughout the piece.

Mortgage-backed securities (MBS). Very high-quality bonds and a focus of this piece.

Separately managed account (SMA). This is where an investment advisor manages a customized portfolio for a particular investor.

Don’t hold cash or CDs. A separately managed account (SMA) of high-quality mortgage-backed securities (MBS) can generate dramatically more income, while keeping the safety and liquidity you want.

Next, explore the risk you are taking in your bond funds and bond alternatives. You may be surprised just how much you can reduce your risk – and how little income you give up – by simply shifting your current bond investments into a separately managed account of high-quality mortgage-backed securities.

Okay … now that you have reduced the risk in your bond-related funds, consider redeploying some of that risk into stocks. Your new portfolio allocation, with more stocks and safer bond investments, might set you up for higher long term returns and better tax efficiency. As a bonus, you will hopefully get more stable income from the safer portion of your portfolio – your mortgage-backed securities SMA.

It’s crucial that the separately managed account be managed by someone who specializes in MBS. In addition, an MBS expert at a smaller shop can often be more opportunistic, and capture more alpha (don’t worry – we will discuss later).

Don’t hold cash or CDs. You can earn way more income on super safe mortgage-backed securities.

Many investors keep a portion of their portfolio in money market accounts, bank deposits or CDs. Sure, that makes sense for near-term liquidity needs. But aside from that, why hold these assets that earn close to zero? An SMA using short average maturity MBS, may target a 1.50% to 2.00% return. If you can allow your SMA manager a little time to raise cash when you need liquidity, you can earn way more income without giving up the safety and liquidity you need. Think about that for a moment … this trade is really a layup. A no-brainer. And it’s something we do all the time for our clients.

A mortgage-backed securities (MBS) separately managed account (SMA) may reduce bond risk. And without giving up much income.

Eliminate credit risk. We have searched for mutual funds or ETFs that can provide a 1.50% to 2.00% return. Most short average maturity bond funds take a material amount of credit risk to try to reach a 1.50% to 2.00% return. They often use bonds rated A or BBB – even high yield bonds. Since I do not want to criticize other funds, I am not providing specific examples, but you can look for yourself. Look at the ratings on the bonds in your favorite bond fund; it’s a smart idea to be aware of these details.

Now, there may be nothing wrong with a fund that takes credit risk. But why take this risk if you can target about the same returns with mortgage-backed securities guaranteed by a government sponsored entity? During difficult markets, credit risk can introduce a lot of volatility and potential losses. The MBS we’re suggesting are issued and guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae – all government sponsored entities. I believe this guarantee greatly diminishes or even eliminates credit risk. These MBS tend to perform well in the most difficult markets, like they did during the Covid crisis of early 2020.

Reduce your interest rate risk. In addition to owning lower rated bonds, many bond funds use longer maturity bonds (riskier and more volatile) in their efforts to reach a 1.50% to 2.00% return. Look for yourself. Look at the average maturity (or duration) of the bonds in your favorite bond fund.

Of course, there’s nothing wrong with a fund that uses longer term bonds. But, unless you want longer term bonds as part of your asset allocation, why take this risk if you can target similar returns using shorter average maturity (lower risk) MBS? During periods of inflation or rising interest rates, longer maturity bonds mean more losses in your portfolio. A mortgage-backed securities SMA, with an average maturity of two to three years, should be able to target a 1.50% to 2.00% return and avoid losses – even when interest rates are rising.

Target a better risk-adjusted return on your bond allocation. Real estate investment trusts (REITs) and many other bond alternatives can generate way more income than our proposed mortgage-backed securities SMA. They’re a great fit in many situations. Yet these bond alternatives can be much riskier, and way more volatile. Their prices may swing 20% to 50% in difficult markets. Look at the price volatility of your favorite REIT over the past 5 years.

In this same difficult market, a mortgage-backed securities SMA with a short average maturity may not go down at all. Your overall portfolio may be better off by accepting a 1.50% to 2.00% return on some of your bond allocation, and redeploying the reduced risk into stocks.

With strategic asset allocation, you can target higher long-term returns, better tax efficiency, and more stable income.

If you shift some of your riskier bond funds, real estate investment trusts (REITs), or other bond alternatives into a short average maturity mortgage-backed securities SMA, you can reduce the risk and volatility in your portfolio. You may or may not give up some income in this reallocation. I would suggest that you then allocate some of that risk into stocks. I think you will pick up far more additional return in stocks than you give up in the reallocation to an SMA using MBS. As a huge bonus, stocks can be far more tax efficient.

I believe this reallocation may give you the following benefits: Higher returns. Less risk in your overall portfolio. Less volatility in difficult markets. And stable income from your mortgage-backed securities SMA.

It is key that the mortgage-backed securities separately managed account be expertly managed. Smaller advisors can be more opportunistic.

Alas, finding this expert may be the hardest part of implementing this strategy. Still, you really need a focused expert to find the pockets of opportunities that can drive the alpha we discussed, and to evaluate and carefully manage the associated risks. In addition, an MBS expert at a small firm can often be more opportunistic than a larger manager and capture more of the alpha that we discussed in this piece.

There are brilliant experts running many large mutual funds. But when they are managing many billions of dollars, it may be hard for them to be opportunistic and cherry-pick the market. Their large size may compromise their ability to generate alpha. Often, these larger managers are forced to take more risk to generate the same return that a small shop may generate with far less risk.

Managing mortgage-backed security SMAs – and the associated portfolio asset allocation – has been one of my specialties for over thirty years.

Summary of ideas: Earn more stable income. Reduce risk.

A separately managed account (SMA) of high-quality mortgage-backed securities (MBS) can be a hidden gem. Under the guidance of an expert manager, this SMA may be able to help you earn more income and reduce overall portfolio risk.

Earn more income. The most obvious benefit is as an alternative to holding cash or CDs. Those assts earn close to zero. An SMA using short average maturity MBS, may target a 1.50% to 2.00% return. That’s a huge difference! Particularly, without giving up the safety and liquidity you need.

Reduce bond risk. You may be surprised at just how much you can reduce your risk – and how little income you may give up – by simply shifting your bond type funds into an SMA of high-quality MBS. Just look at the risks (lower credits and longer maturities) you’re taking in your bond funds, preferred stock, mortgage real estate investment trusts (REITs) and other bond alternatives.

Redeploy risk into owning more stocks. If you shift some of your riskier bond funds, REITs or other bond alternatives into a safe mortgage-backed securities SMA, you should reduce risk and volatility in your portfolio. You can then allocate some of that risk into stocks. I think you’ll pick up far more additional return in stocks than you give up in the reallocation to an SMA using MBS. And, as a huge bonus, stocks can be far more tax efficient.

Find a mortgage-backed securities expert at a small shop. It is crucial that the SMA be managed by someone who specializes in MBS. What’s more, an MBS expert at a smaller shop can often be more opportunistic and capture more alpha.