Why would anyone have a mortgage and a bond portfolio?

We are homeowners with a pretty sizeable mortgage but we also accumulated a nice retirement nest egg, which is actually many times larger than our mortgage. Even our taxable investments are several times larger than the mortgage. Still, we don’t pay off the mortgage because we like the benefit of leverage. We have a liability with a low-interest rate and assets with a much higher expected rate of return, so our overall expected rate of return is higher than without a mortgage. Our friend FinanciaLibre (now a defunct site) did some nice number crunching on this topic recently and we agree wholeheartedly.

Moreover, if you follow our blog you’ll also remember that we take a pretty dim view on bonds:

So, personally, we skip the bond allocation altogether. Others have written about this, too, check Physician on Fire’s 2-part guest post here and here. In light of all of this, here’s one question that occurred to us:

Why would anybody have a 30-year mortgage at about 3.50% and a bond portfolio currently paying around 1.8 to maybe 2.5% interest for safe government bonds?

Leverage works only when the asset has a higher expected return than the liability!

So, just to get everybody on the same page on where we’re going with this post, let’s look at the diagram below: Our blogging friend FinanciaLibre (site is now defunct, unfortunately) showed that if you have a stomach for volatility, you’re better off not paying down your mortgage any faster than you have to. Use the leverage to get higher expected returns in an equity portfolio! (And don’t forget that stretching out the mortgage also reduces Sequence of Return Risk. Also, check out the discussion on this topic in our ChooseFI podcast appearance and the Friday Roundup.) In the diagram: Allocation 1, an all-equity portfolio plus a mortgage, is better than allocation 2, which is also an all-equity portfolio but smaller in size because we just paid off our mortgage.

mortgagevsbonds_chart1
Stock-Bond-Mortgage portfolio allocation: How today’s post fits in with FinanciaLibre’s earlier research

Today, we want to make the case that the inferior portfolio 2 is still not as bad as portfolio 3 with the same equity allocation but both a mortgage and a bond portfolio. If you want to merge the insights from FinanciaLibre and our ERN blog it would mean that bonds are just not very attractive. Even less attractive than we initially thought.

Side note: in more than one way a mortgage is very different from a bond. A mortgage has amortization (principal is paid down over time) while a bond normally pays only interest and then the principal at maturity. In that sense, a bond is more appropriately comparable with an interest-only mortgage. Moreover, most mortgages can be prepaid without a penalty (at least in the U.S.) while Treasury bonds can’t be retired before maturity. Corporate bonds, however often do have a prepayment option. We will talk more about the mortgage prepay/refinance option below. It’s actually one pretty tangible reason to hold both bonds and a mortgage at the same time.

But let’s keep an open mind here. What would be the reasons to still own bonds and keep the mortgage? We can split the reasons into three categories:

  1. One clearly legitimate reason to have both a mortgage and a bond portfolio.
  2. “Reasons” to have a mortgage and a bond portfolio, though they are bad reasons.
  3. Reasons to have a mortgage, though they are independent of holding a bond portfolio. They work just as well to rationalize picking allocation 1 over allocation 2.

1: One good reason to have a mortgage and a bond portfolio: The prepayment option

As indicated above, a mortgage isn’t like a bond. You have the option to prepay your mortgage and refinance into a lower rate loan if the market interest rate were to drop. The U.S. Treasury cannot. So, imagine you hold a bond portfolio and a mortgage and they both have the same principal amount and the same duration/interest rate sensitivity. (Side Note: intriguingly, a 30-year mortgage has an interest rate sensitivity more in line with a 14 to 15-year bond, rather than a 30-year bond, due to the amortization schedule). If the prevailing interest rate goes up your bond portfolio value goes down. How about the mortgage? The principal value may have stayed the same but the future cash flow of mortgage payments amounts to a lower present value at that higher interest rate. It’s a wash.

mortgagevsbonds_chart2
The refinance option on the mortgage works like a put option on the interest rate level!

But if interest rates were to go down your bond portfolio appreciates and you can lock in a lower mortgage interest rate. The best of both worlds! Having a mortgage and the bond portfolio is essentially a put option on the interest rate. Could it be useful to suffer a little bit of negative carry? You bet!

But there are still some limitations:

  • Transaction costs. For the refi to be worthwhile the rate would probably have to fall by at least 0.25% to make this whole refi exercise profitable
  • In the U.S., interest rates are on the way up. True, we could have another recession soon and the Federal Reserve can go bananas again with more rounds of quantitative easing. But my baseline forecast is that the mortgage refi party will be on hold for at least a number of years. Why pay that negative carry without any likely benefits for years?

2: Bad reasons for simultaneously having a mortgage and bond portfolio

Now let’s head over to the second category: Reasons that are actually bad reasons:

2a: Tax arbitrage

Comparing raw interest rates between bonds and mortgages is not 100% fair. Mortgage interest is tax-deductible. Though, bond interest income is taxable at our personal ordinary income tax rate, too, if held in a taxable account. Thus, the only way to push the needle in favor of a bond portfolio is to assume your bonds are held in a tax-advantaged account (IRA, Roth, 401(k), etc.) and you get a nice mortgage interest deduction.

Even the mortgage deduction is not a 100% slam dunk. If you have an income high enough to put you deep into the alternative minimum tax (AMT) zone, then congratulations: Potentially, your entire mortgage interest cost is effectively deductible at your high marginal tax rate. That could be 35% federal (28% AMT plus 7% for the phase-out) and another, say, 7% for the state rate. Your 3.5% mortgage just became a 2.03% mortgage.

Of course, if you don’t fall into the AMT, recall that you get a $12,600 tax deduction for free (2016 federal standard deduction, see here). Unless you have a lot of other tax deductions your mortgage may not have any effective tax advantage at all. Especially if your mortgage principal is “only” in the low six figures. See our post Good and Bad Reasons to Love the Mortgage Interest Deduction!

But it gets worse. I personally don’t buy the argument that the bond portfolio in scenario 3 can be entirely tax-free either. First, if bonds are held in a tax-deferred account (401(k), regular IRA, etc.) you will only defer income taxes, rather than completely avoid them. In the chart, the middle bar is the after-tax return if we assume we compound and defer the bond interest for 10 years and then pay 15% marginal on the gain: Yd=(1+((1+Y)^10-1)*0.85)^0.1-1.

With the 10-year Treasury bonds yield right below that number (around 1.8% lately), there is no money to be made from tax arbitrage. Going with longer maturity safe bonds (10-20-year) we’re still underwater. If we could hold the 20+Y bond Treasury Bond ETF in a tax-free account and get the full mortgage tax-writeoff, we do get about 0.50% in positive carry (but see the limitation below).

BongYield_vs_MortgageRate_Table2.png
Bond Yields vs. Mortgage Rates (Source: iShares.com, 10/28/2016)

How about putting the bonds into a Roth IRA where we can get the entire yield tax-free? There is still a cost. You crowd out your equity holdings that would have otherwise enjoyed the Roth treatment, see chart below. Why does that matter? If you are currently in a high enough tax bracket you pay taxes on dividends. Lots of them! 15-20% federal, 3.8% Obamacare and state taxes as well for a total of more than 25% marginal in the ERN household. Thus, the bond interest may be tax-free, but the side effect is a 0.50% p.a. tax bill from holding more equities in a taxable account (given a 2% dividend yield in the S&P500)! That will likely wipe out any tax arbitrage for us! One way around this issue with the “limited space” in the Roth: Do the Synthetic Roth IRA through futures trading as we described before, but that’s only if you have the appetite for some serious financial hacking!

mortgagevsbonds_chart3
Crowding out equities from tax-deferred accounts may expose us to taxes on dividend income!

And, needless to say, once we’re retired all tax arbitrage will be gone: We will no longer itemize deductions on our federal return and use the generous standard deduction for married couples instead. So, for us personally, there is no tax arbitrage for holding bonds and a mortgage at the same time. We might as well pay down the mortgage and forego the bond portfolio (allocation 2) or just go the FinaniaLibre route and invest in equities (allocation 1). We currently do the latter.

2b: Loading up on credit risk (intentionally or unintentionally)

I already hear one objection to our analysis: Why not invest in higher yielding bonds? The more adventurous we become the more yield we can generate. With some of the bond funds, you can actually go above the raw mortgage rate of 3.5% and most of them beat the after-tax mortgage rate of 2.03 if held in a tax-deferred or tax-free account. Just a sample of bond ETF yields from iShares (as of October 28):

bongyield_vs_mortgagerate_table1
Bond Yields vs. Mortgage Rates (Source: iShares.com, 10/28/2016)

But it’s not arbitrage. Any asset with higher yield and more risk than U.S. Treasury bonds is not really generating arbitrage, but rather it’s piling on risk. Unless our mortgage lender confirms (in writing!) that they will give us a break with the mortgage in case our bond portfolio blows up this is not the money making machine we thought it is. You may generate positive carry but at the cost of substantial risk.

2c: Mental accounting/Peace of mind

Mental accounting is a behavioral bias that makes you compartmentalize your economic decisions. This always leads to sub-optimal outcomes as we described here. Nevertheless, mental accounting would be a reason for folks to simultaneously hold a mortgage and a bond portfolio. It’s a bad reason, but it’s still a reason.

So someone who holds a stock plus bonds portfolio and a mortgage at the same time may not make the connection between the bond portfolio and the highly correlated short bond position in form of the mortgage. You may think that the bond portfolio in allocation 3 hedges your equity risk. But in the end, the bond and mortgage risk cancel each other out in the realm of pure economic/financial risk factors. Then all you’re left with is a negative carry from the interest rate differential with no true risk mitigation.

3: Reasons to have a mortgage, completely independent of the bond portfolio

And finally, here’s the third category. Legitimately good reasons for having a mortgage, though they don’t necessarily mean you should hold bonds. They work just as well as a rationale to hold equities and we’re back to the Allocation 1 vs. 2 in the FinanciaLibre exercise.

3a: Protection against lawsuits

We live in a dangerous world; as affluent Americans, we have a huge target painted on our backs. Personal injury lawyers would be just too eager to slap us with a frivolous lawsuit and a mortgage-free house in our name would be the grand prize for the ambulance-chasers. On the other hand, a hefty mortgage could be just the legal poison pill that makes going after my primary residence quite unattractive. (One exception to the rule: Florida exempts your primary residence from creditors’ access in bankruptcy. So you don’t need the help of a mortgage for asset protection in that case!)

3b: In some states, a mortgage is a put option on your home value

If you own a house outright your maximum loss is the value of the house. With a mortgage, you can lose only your home equity if you live in a so-called “non-recourse” state (there are 12 of them, according to FinancialSamurai). You can default on your mortgage, hand in the keys to the bank and walk away from your house. The bank cannot go after your other assets (it has no recourse, after all). If you’re really nasty you stop making payments to the bank and live in the house for free until the foreclosure process goes through, which can last anywhere from months to years.

Ripping off your creditors like that may sound morally and ethically suspect but this sort of default risk is already baked into your mortgage rate. You pay extra for this risk and you might as well make use of this option when the time arises. Of course, this method only works in states that have the “non-recourse” provision. If the bank can go after your other assets then this entire argument is moot.

Do you have a mortgage? Do you own bonds? Do you have positive carry (after-tax bond yield > after-tax mortgage interest)? Have you considered selling bonds to pay down the mortgage or shifting to equities instead? Please leave your comments below!

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23 thoughts on “Why would anyone have a mortgage and a bond portfolio?

  1. Wow!! Some serious shouts goin’ on up in here! I’m not worthy…I’m not worthy…!

    Very honored to be mentioned, ERN. This is a beautiful analysis. And I can’t add anything to it. But I will say I especially like your discussion of the lawsuit risk and “poison pill” concept. I hadn’t really considered that side of things, but there hardly seems to be enough someone can do to insulate from the costs and risks of litigation in the U.S. these days. If mortgage debt is even a weak deterrent, that might justify any interest expense right there…even if the levered value is held entirely in cash or something really stupid like gold or even stupider like an attorney retainer!

    Thanks for adding much to the discussion on the mortgage topic. Your analysis takes it to the next level. I think we can now be fully satisfied the question of mortgages has been laid to rest. Great work, and thanks for the shout!

    Liked by 1 person

  2. Some great points. If your not earning as much as your paying then the debt should go. I still hold bonds but the performance has been on par with my mortgage. I have been thinking to lower my allocation though, and this is a good reason.

    Liked by 1 person

  3. Oh crap. I hold bonds ( you knew that anyway). I paid off one mortgage and still hold another one. My bond fund is beating out the mortgage rate quite handily but for how long we will see….

    Will you still talk to me ? Have you unfollowed me on Twitter? Am I doomed to a life of hell in FIRE? I need answers and quickly!!

    As for the litigation issue, another reason to accelerate umbrella insurance purchase……

    Jeez, more stuff to do in an otherwise busy period for the PIE’s.

    Liked by 1 person

    • Haha, no worries. There will be no Spanish Inquisition knocking on anybody’s door for holding bonds and a mortgage. But out of curiosity: How did you beat the mortgage interest? With the yield alone or yield plus capital gains? If it’s the latter, I would keep in mind that the interest rate compression can’t go on forever. I would even argue we’re on the way up with interest rates, which means bonds will lose in value.
      Good point about umbrella insurance! Very important for high net worth households!
      Cheers!

      Like

        • Thanks! But how much of that was interest income and how much is capital gains? Example: The AGG (iShares ETF) gained 4.15% YTD (to Nov 2). About 5% annualized. But the fund only has a yield of 2.3%. Going forward, only the yield is guaranteed (and even then you get some slippage from defaults on corporate bonds). If interest rates rise again that 2.7% extra return in addition to the yield can easily not just evaporate but turn into a -2.7%. It doesn’t take much to wipe out a yield 2.3%. The AGG has a duration of 5.36, so a rise in the interest rate level by 0.43% and the AGG returns zero over the next year.
          Has happened before, remember this:
          https://earlyretirementnow.com/2016/05/19/bond-vs-stock-risk/

          But: I’m not predicting that rates go up or down, I’m just saying that we shouldn’t bank on permanent capital gains in bonds. In fact, I hope that there won’t be bond market mayhem and instead, interest rates rise only very slowly. Not because I own bonds but because I don’t want the economy to take a hit.

          Cheers!

          Like

  4. We’re largely in agreement here. A mortgage payment is like your bond allocation. Unless your bond return after taxes sufficiently outweighs your mortgage interest it isn’t worth it to have both in an allocation. I did recently note that one savings bond, EE bonds do exceed the returns of mortgage interest after tax ramifications in which case if the choice is to pay a mortgage or hold the bond then the bond comes ahead. However that’s an exception with a long list of caveats.

    I do have one more exception though. Some bonds or bond like holdings are liquid. A mortgage is not. Needless to say that’s situation dependent but they might come out ahead with a near term large purchase.

    Liked by 1 person

    • Liquidity is a major issue. It will take weeks to get the mortgage but only days to get money out of a bond mutual fund. So, I would never argue to pay down the entire mortgage by wiping out the entire taxable investment portfolio. I would always keep some liquidity left in the portfolio. Or even better: Don’t pay down the mortgage but go into equities. Equity funds are just as liquid as bond funds.
      Regarding the EE bond: I wonder which one that is. Interest rates for safe government bonds all pay pretty pathetic interest rates:
      http://www.federalreserve.gov/releases/h15/

      Like

  5. No bonds here- I take the money that would be for safe allocation (i.e about 20%) and make sure it goes to student debt. Once that is gone, then I can work on paying off that peaky mortgage as I see fit. First I gotta build that nest egg that can hatch into a beautiful hen and make more eggs for me.

    Like

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