A fixed income investment which works in an inflationary world?

Published: Sat 04 June 2022
Updated: Sat 04 June 2022
By steve

In markets.

Saturday 4, June 2022

Mortgage REITs

Harley Bassman is highly regarded. He’s very knowledgeable about mortgage-backed securities. He has written about the fact that MBS REITs might be a profitable (long) investment in the current rate environment. The basic idea is that they are priced as a bond with an embedded short call option. With rates likely to go up, this call option may be priced above its ‘true’ value. You can read about the thesis here.

I think that to take advantage of shorting the embedded expensive option, you probably have to hedge the pure bond part of the security. This sort of trading is strictly for the professionals, I think, but it certainly reminds one that for the bulk of MBSes there is no credit risk, because they are all guaranteed by Freddie Mac or Fannie Mae.

Oddly, back in the eighties, I did knock up a model for valuing MBSes, long before they became well known as the cause of the 2007 crash. It was as a classroom exercise. The model was never tested in the real world.

The Economist is predicting a recession

What America’s next recession will look like.

There is a lot of stuff on Twitter about JPoww piloting the US economy down to a soft landing. One way to do this is to hold the real interest rate at its neutral level, at which it is neither contractionary nor expansionary. The Economist thinks that this is 0.5%, but to hit this with inflation running at 8% will be impossible. So, the economy will accelerate skywards, with a deeply negative real rate, before eventually the Fed has hiked enough times to bring the nominal Fed Funds rate to something like the inflation rate. This will take a long time, by which the economy will have run out of fuel and will be diving vertically … maybe.

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