For investors and financial advisers sitting on excess cash while waiting for the Federal Reserve to raise interest rates, a narrow band of the
mortgage-backed securities market might be the right tool at the right time.
A 1.75% yield and a slightly higher total return won't stack up very well against most equity markets, but it sure looks nice when compared with those of money market funds and even a lot of Treasury bonds.
The key, according to Hugh Lamle, president of M.D. Sass, is to concentrate on mature mortgages held by borrowers with high credit scores and low mortgage balances.
Those are the folks least likely to refinance, which effectively eliminates the interest coupon payments for investors in MBS.
“A factor we look at is the remaining mortgage balance, because the cost of refinancing is often so great that it doesn't make economic sense for those with small balances of $100,000 or less,” Mr. Lamle said. “So, you wind up with high coupons from mortgage holders that have a low propensity to prepay or refinance.”
M.D. Sass, which has $7 billion under management, including $3 billion in MBS portfolios, is concentrating on mortgages with between one and three years remaining, for an average duration of two years.
The bet is that the borrowers won't refinance over the final few years of the mortgage contract, said Nick Betzold, managing director at Incapital.
“There's value to be found out there, but you have to look very carefully at loan-to-value and loan size,” Mr. Betzold said.
RISK
J. Brent Burns, president of Asset Dedication, said he employs a similar strategy but not in government agency mortgages from
Fannie Mae and Freddie Mac, which is the M.D. Sass model.
“There is a little more juice in the agency bonds, but if it hits the fan, those will be the first to go,” Mr. Burns said. “They give a little boost relative to other agencies because of the increased perceived risk. They're still safe, assuming the government continues to make good on the payments, which is highly likely.”
Mr. Lamle, who has been running the strategy in separate accounts since 1993, and in a mutual fund since 2011, prefers the agency-backed mortgages over private mortgages because it eliminates the credit risk.
The $93 million mutual fund, M.D. Sass 1-3 Year Duration US Agency Bond Fund (MDSIX), gained 1.41% last year and was up 34 basis points this year through Thursday. That compares with short government fund category average gains, as tracked by Morningstar Inc., of a 96 basis points last year and 48 do far this year.
Like most bond strategies right now, there is a looming risk that higher interest rates will drive down asset values. But Mr. Lamle said his strategy, which generates between 3% and 5% in monthly cash flow as mortgages mature and are paid off, continually reinvests in more short-duration mortgages, which creates a kind of bond ladder.
In the 20-plus years M.D. Sass has been running the strategy in separate accounts, Mr. Lamle said, it has never had a losing year. Since 1993, the strategy has had six negative quarters, compared with eight for comparable Treasury bonds, and on a total-return basis it has had two down six-month periods, versus six for Treasuries.
The mutual fund, which has a
four-star rating from Morningstar, also gets high marks from S&P Capital IQ.
“We rank the fund as a four-star, which is helped by its strong track record relative to Lipper's short-U.S. government peer group and a modestly lower expense ratio (of 0.7%), said Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital.
“The fund does incur a slightly elevated standard deviation, which is one offset,” he added.
