The Government Bond Play That Can Stretch Yields To 5-X More Than Treasuries

 |  Includes: AGG, MBB
by: YCharts

The global flight to quality of the past year has pushed U.S. Treasury yields from merely very low to "this is crazy" low, and the rate cut in Europe won't do anything to change that.

10 Year Treasury Rate ChartClick to enlarge
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10 Year Treasury Rate data by YCharts

Sure, there's the sleep-at-night factor that U.S. Treasuries are immune from default risk. But even if you're in the camp that is more focused on "return of principal" rather than "return on principal" there's another slice of the bond market worth a look-see.

Mortgage-Backed Securities (MBS) that are backed by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac) deliver Treasury beating yields with basically the same rock-solid government backing.

Ginnie Mae bonds are fully guaranteed by the government. Both Fannie and Freddie are what is known as government-sponsored enterprises (GSEs); there is just an implicit, rather than explicit promise that Uncle Sam guarantees the timely payment of interest. Let's just say it would be a market-rattling seismic event if the government ever gave a whiff that it wasn't backing the bonds. And you know how much the government wants to avoid that sort of thing in this market environment.

Shifting some of your Treasury stash into mortgage-backed securities is a nice way to pick up a nice yield boost without taking on credit risk. Right now a 3-year Treasury bill yields 0.39%. The distribution yield on the $5 billion iShares Barclays MBS Bond ETF (MBB) is about 2% right now, and its effective duration is just 2 years.

Granted, 2% isn't going to make you rich; it barely keeps pace with inflation. But if you're camping out in Treasuries right now, you're obviously more interested in the "insurance" that comes with a government backstop. Why not pick up some incremental yield by moving some of your Treasuries into MBS?

You could add the iShares Barclays MBS ETF to your mix. Or another option is to go with the broader Barclays Aggregate Bond ETF (AGG) that mimics a benchmark that includes Treasuries (35% of the index) MBS (30%) and investment grade corporate bonds (20%.) The broader ETF yields 2.5%. It's wider asset mix and longer duration (about 4.5 years currently) has produced a stronger total return the past five years.

AGG Total Return Price ChartClick to enlarge
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AGG Total Return Price data by YCharts

Just keep in mind that duration is a measure of interest rate sensitivity. A portfolio with a 2-year effective duration will see the price of its bonds decline 2% in a year where interest rates rise by one percentage point. A 5-year duration translates to a 5% price drop.

Carla Fried is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.