Data is correct up to the time of publishing.
Any recommended trade is in my personal portfolio.
This is not financial advice.
Preview
The business cycle has been defined by a quantitative tightening regime brought about by the Fed, but there is some indication of renormalization in the economy. Although rates have still not been cut and yields are rising, inflation is reducing and the job market seems to be stable. However, because of this interesting situation in the economy - equities and treasury yields are up YTD - looking to other asset classes for clarity and return may be attractive to investors. Mortgage-backed securities offer scope for return, but it is essential to identify which specific ones can offer that return. Floating-rate mortgage-backed bonds are going to be composed of poor credit quality debtors, and with the rising rates, likely refinancing and defaults may affect the profile of these MBSes. However, agency-backed fixed-rate MBSes can offer both yield in times of high rates, lower credit risk, and minimization of portfolio volatility due to low equity correlation. Although the Fed may not necessarily initiate a quantitative easing regime immediately due to mixed signals from the economy, with real GDP increasing, inflation decreasing, and the velocity of M2 money stock increasing, rate cuts are due in 2024. However, because of the inexactness of when these cuts will actually happen, the stagnancy in the housing market, and the persistent inversion of the yield curve, it is vital to be prudent about the MBB investment vehicle.
BlackRock iShares MBB ETF
The BlackRock iShares MBB ETF is comprised of US government-backed AA-rated mortgage-backed securities. Some important metrics:
Weighted-average maturity: 8.21 years
Weighted-average coupon: 3.05%
Average yield-to-maturity (YTM): 5.43%
Convexity: 0.28
Equity beta: 0.24
The long-term durations indicate that the underlying mortgages would not be as affected by the expensive short-term maturities brought about by high rates. The low coupon - lower than the 30-year US Treasury - again indicates the high credit quality and AA-nature of the comprising bonds. Additionally, the high YTM and low convexity point to a rate-protected strong yield profile of the ETF, as the bonds will not be as sensitive to interest rate fluctuations. Finally, the low equity beta offers motivation for a portfolio allocation by not only 60-40 portfolio managers but long/short equity hedge fund managers and equity desks & traders; this can provide a hedge against the potential recessionary pressures on equities. Pure fixed-income investors and traders - specifically high-yield focused ones - can benefit from having a short-term hedge using the MBB ETF, as the markets may move from seeking yield to longer-term bonds and US Treasuries once rate cutes commence.
Investment Vehicles
Naturally, distilling a view into a trade or investment is the end goal. The question is, what vehicle is appropriate? Although MBB is down 3.17% YTD, the market seems to be pricing in rate cuts and eventual quantitative easing (in this case, government purchases of MBSes from the market) as the ETF has been up 4.38% the past month. I believe long options are the best vehicle, as the downside is fixed and the upside is unlimited. Additionally, in a trade like this, it is important to choose the exercise date and strike price carefully to maximize the convexity of the option return. As rate cuts may not necessarily happen in early 2024, there is more uncertainty about the actual start of the cuts. Additionally, as the cuts - at least in the MBB ETF - have not been priced in entirely, an optimal strike choice is essential. With this in mind, I decided to purchase an OTM (Out-Of-The-Money) call option with a Jan 17, 2025 expiry at a strike of $92; I chose this strike and expiry with the expectation that the intrinsic value of the call will eventually increase once the market begins pricing in the cuts fully. As the option did not have intrinsic value, I could buy it cheaply - again, to increase potential convexity.
Information on my trade:
When I bought the call on October 6, 2023, MBB closed at 87.32; it closed at 90.25 as of Nov 27, 2023. From open, the position has generated 81.25% return.