The Subprime mortgage mess and its aftermath were partly the result of risks not being priced appropriately. Interest rates for risky mortgages and bonds should have been much higher given the level of risk involved. As financial markets still recover from the aftermath of risk being underestimated, there is a good chance that there are now areas where risk is being overestimated. This week’s issue of Barron’s has two interesting suggestions in this regard.
I’ve written elsewhere about the limited returns available for investors in traditional cash investments like money market funds and bank accounts. For now, it looks like the federal government is back-stopping those investments with FDIC insurance and a new guaranty fund. But the returns are still meager.
The government has essentially taken direct control of Freddie Mac and Fannie Mae. Even though their debt obligations are not identical to Treasuries, the federal government is now explicitly backing FNMA and FHLMC debt for the foreseeable future. Mortgage-backed debt is now much less risky than it used to be. While 10-year Treasuries yield about 3.8%, there are government-sponsored agency bonds with even shorter maturities paying 5% or more. If you buy such securities and hold them to maturity, the risk of a default is negligible. You might also consider government-agency mutual funds, but keep in mind that the values of these funds will fluctuate over time with changes in interest rates.
The Barron’s sidebar also notes that there are some great bargains in municipal bonds. These will only be of interest if you’re in one of the higher tax brackets, but some munis are backed by Treasury securities held in escrow, yet they still yield 5% or more. Higher-income households with a need for long-term tax-free income have a window of opportunity that will probably close once the markets begin pricing in the fact that these are really low-risk investments.
Disclosure: I don’t own any of these types of bonds right now.