Where To Maximize Safe Stable Income: Not In Credit Or REITs

Are you looking to generate stable income and protect a portion of your capital from losses?

The hardest thing to figure out may be if you really want a safe, stable, relatively bulletproof income producing portion of your portfolio.

• Is it important to you to have a safe stable income stream?
• Will you sleep better at night?
• Is it a helpful diversification for your portfolio?
• Are you more concerned about staying rich than getting rich?
• Do you or your business tend to keep large amounts of cash?
• Are you overseeing trust or nonprofit assets that need to stay safe and stable?

If your answer to some of the above questions is yes, I implore you to consider my suggestion. It really works. In all markets. Always. This has been my specialty for almost 40 years. Believe me, I know this stuff. I encourage you to ask questions. Challenging questions are great. You can message me through Seeking Alpha. Or you can give me a call.

The only asset to generate safe stable income may be high quality short-term bonds.

Short-term high-quality bonds may be the only asset that can generate safe stable income in all markets. This year is a great example. Longer term bond indexes are down over 10%. High yield is down closer to 15%. Emerging market bonds are down about 20%. REIT indexes are down about 20%. There is nothing wrong with holding any of these assets. Still, is that what you want as a cash alternative or for the safe and stable portion of your portfolio?

High quality. Eliminate credit risk. Treasuries are guaranteed by the US government. The MBS we’re suggesting are issued and guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae – all government sponsored entities. I believe these guarantees greatly diminish or even eliminate credit risk. These MBS tend to perform well in the most difficult markets, like they have this year, and like they did during the COVID crisis of early 2020.

Many short average maturity bond mutual funds or ETFs (VCIT, BSV) take a material amount of credit risk to stretch for return. Why take this risk if you can target about the same returns with mortgage-backed securities (MBS) guaranteed by a government sponsored entity? During difficult markets, like this year, credit risk can introduce a lot of volatility and potential losses.

Short-term bonds. Reduce your interest rate risk. The longer the maturity of a bond, the more the price of that bond will change with changes in interest rates. This year is a vivid illustration. Longer term bond indexes are down over 10% this year. The prices of short (high quality) bonds don’t change that much with changes in interest rates. Thus, they may be the best asset to generate safe stable income.

There’s nothing wrong with a fund that uses longer term bonds (NASDAQ:BND, VBTLX, NYSEARCA:AGG, PTTRX, FXNAX, DODIX, PTY). But, unless you specifically want longer-term bonds as a strategic part of your asset allocation, why take this risk if you can target similar returns using shorter average maturity (lower risk) Treasuries and MBS?

MBS may be the highest yielding asset that can generate safe stable income – in the hands of a manager who knows how to manage the risk.

Mortgage-backed securities (MBS) are typically the highest yielding super high-quality asset. They have yields that are much higher than Treasury bonds and generally higher than corporate bonds (that have more credit risk). The challenge is that they are more complicated (not riskier) than most corporate or Treasury bonds. Because of their complexity, I would discourage individual investors from buying MBS from their brokerage firm. Chances are that neither you nor your broker will understand the complexities or risks in the bond. In that light, I would suggest that individual investors stick to mutual funds, ETFs or an SMA. An SMA can position you to maximize returns, better manage risk, and have the portfolio customized to your specific needs.

To maximize safe and stable income, get a smaller manager that can be more opportunistic and generate a lot more income. It is key that the mortgage-backed securities separately managed account be expertly managed.

An MBS SMA with about a two-year average maturity can currently target about 4.00%. Short maturities should help the portfolio avoid material losses when interest rates are rising (like this year). I think these SMAs are the best choice to maximize safe stable income.

Alas, finding an expert may be the hardest part of implementing this strategy. An MBS expert at a small firm can often be more opportunistic than a larger manager and thus, generate lots of extra income. We have been doing this for decades. It works. Consider this illustration. Imagine you are looking to buy a used car. You can go to a car dealer and pay retail. What if, as an alternative, you can pay a small fee to an expert to buy the car for you in a used car auction at a dramatically lower price. As a bonus, the expert can better evaluate the risks associated with owning that car.

At a large shop, like Fidelity, you are paying full retail for the MBS. Like going to the car dealer. At my firm and, I imagine, other smaller shops, we typically buy bonds for our clients in auctions. That can often provide 50 to 100 basis points (0.50% to 1.00%) of extra yield. In addition, an MBS expert can carefully evaluate and manage the interest rate risk. In summary, I believe that an MBS expert at a smaller shop can get clients a lot more return with less risk. This totally works. This strategy has been my firm’s specialty for over 25 years.

REITs are enticing. But their prices can often drop 25% or more

REITs (NLY, AGNC, TWO, IVR, ARR) are very enticing. Many offer dividends of 10% or more. I own a few. One of them paid a 10% dividend in 2021. That’s amazing in a low-rate environment. The surprise was that the 10% dividend was simply a return of capital (what many REITs do). REIT dividends can be very deceptive. Over the past year, the book value of my REIT has fallen about 20%. And the stock price is down about 40%. Many REITs have followed a similar path. Be careful in this sector.

REITs may be appropriate for your portfolio but the above illustrates why most REITs are a horrible choice to generate safe and stable income. I would prefer to see investors use an SMA of MBS as a much lower risk income producer. And then own more high-quality stocks to bring back up the expected return of your portfolio. I believe you end up with lower risk and higher returns.

Owning 100% stocks may be a great choice. But not for everyone.

Some of the most successful stock investors I have ever met were from Omaha. They have owned nothing but Berkshire Hathaway (BRK.A) (BRK.B) stock for 40 years. I have been a long-term holder of stock indexes (and some Berkshire). Stocks are great. But stocks are not a fit for 100% of most people’s portfolios.

If you are looking for safe and stable income, I compel you to consider an SMA of MBS. And to find a small manager that can generate the highest possible returns. My firm has been managing these SMAs for clients for over 25 years. High quality MBS has been my personal specialty for almost 40 years. If you want to maximize the income that you generate on the safe, stable portion of your portfolio, we can really help.

Conclusion

Under the right manager, an SMA of high-quality short-term MBS may be your best choice to maximize safe and stable income and can be a safe harbor in all markets. These SMAs can currently target about a 4.00% yield (with a 2-to-3-year average maturity). As a bonus, an MBS separate account may have far lower risk and volatility than most bond ETFs or mutual funds targeting a similar or often lower yield.

For more details and a discussion of how an MBS SMA might benefit your overall asset allocation, please look at my prior articles:

Inflation And Rising Interest Rates Short Duration MBS Can Be A Safe Harbor

Generate More Income And Maintain Safety With Mortgage-Backed Securities

Protect Against Inflation And Earn Stable Income With Mortgage-Backed Securities

How can I help?

I can answer questions you post in comments. Challenging questions are great. You can message me through Seeking Alpha. Or you can give me a call. And please follow me so that you can see my future articles.