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Strategies & Market Trends : World Outlook -- Ignore unavailable to you. Want to Upgrade?

To: mishedlo who wrote (1952)	4/25/2003 10:53:57 AM
From: Don Green	Read Replies (1) \| Respond to of 49121

Got a Big Mortgage? Buy More Bonds. Ira Carnahan, Your home loan isn't just a financial stretch. It's really a short position in the fixed-income market. How much of your portfolio should be invested in bonds? You've likely already considered the normal stuff such as your tolerance for risk, when you'll need your money and your outlook for the bond--versus the stock--market. But there's another variable you should factor in and it's one most folks overlook: the mortgage on your house. So says the Wharton School's Christopher Mayer. When you take out a fixed-rate mortgage for $400,000, you're taking the equivalent of a $400,000 short position in bonds. Do you want to short the bond market? This risky bet would lose money if interest rates fell, but pay off if rates went sky-high. Maybe you want to speculate on bond prices, maybe not. If you are like most homeowners, you haven't even thought about your mortgage that way. Consider what happens if interest rates rise sharply. You, as a borrower, make out great. Rates are high (probably) because inflation has picked up, meaning you can repay the principal with cheap dollars. Meanwhile the fellow who invested $400,000 by buying your mortgage is sitting on a paper loss. The IOU's value might shrink to $300,000. (Just this sort of problem bankrupted thrifts a generation ago.) In similar fashion, sharply rising rates could turn a $400,000 investment in bonds into $300,000 faster than you can say "Alan Greenspan." So if you've got a big mortgage, consider holding more bonds than you otherwise would as a hedge against the short position represented by your mortgage. One hedging option is to invest in a mutual fund that holds mortgage-backed securities, such as Fidelity Mortgage Securities Fund (current yield: 3.2%) or Vanguard GNMA (5.2%). These are particularly good at counterbalancing a home mortgage because they consist, at bottom, of other people's mortgages. Built into almost all mortgages is a call option. If rates fall, the borrower has the right to call in the IOU--that is, pay off the debt early--by refinancing. This call option has the effect of mitigating the damage a borrower suffers during a decline in rates, while lessening the potential gain for the investor who owns the mortgage (or a Ginnie Mae). The call does not eliminate the effect of rate changes because there is still a big frictional cost to refinancing (appraiser's fee, points and whatnot). Treasury bonds are (mostly) noncallable, so they are not a good hedge for a mortgage borrower. If you have $400,000 in your taxable brokerage account, you'd do well to just pay off the mortgage. No sense borrowing at 6% just so you can collect 5% at Vanguard. But what if the $400,000 is tucked away in a tax-deferred 401(k) account? Then you have a nice little tax arbitrage on your hands. The interest cost is deductible immediately, while the offsetting interest income is taxed decades hence. There's another way to arbitrage, although you have to be careful not to run afoul of the Internal Revenue Service. Borrow at under 6%, fully deductible, while investing at 4%, tax free, by owning a municipal bond fund. Now you can't just take out a home mortgage and then plop the proceeds into a muni fund. But if you took out the mortgage when you were young, and later accumulate savings or an inheritance, you are under no obligation to pay off the mortgage with your cash. You can continue to take deductions for the mortgage interest while using the new cash to buy the muni shares. An intermediate-term muni fund would be a good match for a long-term fixed-rate mortgage. What if you don't have a 15- or 30-year fixed mortgage? Say your loan adjusts in five years. Then pick a shorter-term bond fund, like Vanguard's Limited-Term Tax-Exempt Fund, with an average duration of 2.6 years (yield: 2.1%). Finally, what about the mansion that mortgage is paying for? A collapse in home values would wreck your net worth. Should you hedge the house, too? That's not easy to do, says Yale School of Management's William Goetzmann. The best protection here is to lessen your overall level of financial risk. Have plenty of cash and buy some life insurance. forbes.com