Bill Gross of PIMCO is the bond king. He manages the largest fund in the world, PIMCO's Total Return Bond Fund, with assets totaling nearly a quarter-trillion dollars.
So it should come to little surprise he's also one of the most influential fixed-income investors. Recently, he shared his favorite way to play bonds against the backdrop of a possible Federal Reserve taper.
What would Bill Gross do?
In a tweet from Pimco, Gross laid out his simple strategy for positioning for interest rates. Here's the Tweet:
Gross: An investor can replicate the 3.9% yield of a 30 yr Treas with a 400% position in 3 yr Treas with a stand pat Fed. Take the latter.— PIMCO (@PIMCO) December 3, 2013
Basically, Bill Gross is a fan of using leverage to buy the three-year U.S. Treasury to get a yield similar to the 30-year bond.
This is, to some extent, what mREITs such as American Capital Agency (NASDAQ:AGNC) do. Mortgage REITs borrow money for as little as 30 days to invest in long-dated mortgage-backed securities to get big yields. Sure, mREITs aren't buying investments that mature in as little as three years, but the concept is similar: Borrow short to invest long.
The key to mREITs and Gross' strategy
Investors are worried about a taper. But Bill Gross' point is that a taper probably won't affect short-term interest rates. Federal Reserve members have repeated, over and over again, that quantitative easing would probably end well before the Federal Reserve tinkers with short-term interest rates.
Thus, Gross is comfortable borrowing short-term capital to invest in three-year bonds to generate a larger yield.
Remember, Annaly Capital (NYSE:NLY) and American Capital Agency fund their portfolios primarily with 30-day cash borrowed at 0.35% and 0.41%, respectively. Their low funding costs should persist, even if long-term rates rise. Annaly Capital and American Capital Agency would love to continue to borrow at less than 0.5% to invest at 5% or more.
Taper's risks to mREITs
For now, American Capital Agency and Annaly Capital just need to navigate the initial start to rising mortgage rates. Both have reduced leverage and cut their exposure to 30-year mortgages in advance of an expected end to quantitative easing.
Now it's just a waiting game. When rates go up, American Capital and Annaly Capital will see more book value erosion. But on the other side of rising rates is huge potential -- the potential to borrow at 0.5%, invest in mortgages at 5%-7%, and reap massive spreads that can fuel big dividends.
If you think the Fed's taper will come slowly, and short-term rates will stand near zero, mREITs are the perfect way to make that wager. A slow, steady taper and steeper yield curve will eventually prove to be a boon for mREITs' interest spreads.
Fool contributor Jordan Wathen and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.