With interest rates at record lows and relatively rich fixed income valuations across many sectors the bond market is becoming an increasingly tricky place to navigate. As a result I find myself researching new ways to squeeze returns out of this segment of the market on a near daily basis. Increasingly, I feel like I am squeezing blood from stones.

One place where that blood is becoming increasingly difficult to squeeze is in the mortgage backed securities market which has been a wonderful place to be in fixed income for the last 7 years. In essence, if you understood that the default risk of the US government was low (something that I’ve been harping on for years) then the agency MBS space looked like a pretty attractive relative income source. You were essentially buying high yield bonds with a government guarantee. This is no longer the case and the MBS market is starting to look a lot more like the rest of the low yielding bond market.

Yesterday, I was researching a bunch of mortgage backed securities funds that I hadn’t looked at in a while and I mentioned on Twitter that they all appear benchmarked in a rather misleading way. That is, many funds like the TCW Total Return, DoubleLine Total Return and Western Asset Mortgage Backed Securities are benchmarked to the Barclays US Bond Aggregate, but they actually operate a lot more like the bond aggregate with a lower credit quality tilt. For instance, on a 5 year basis the R-Squared of each fund relative to the Barclays agg is 53.5, 66.34 and 20.67. So, not exactly apples to apples. The credit quality is certainly lower in these funds, but that doesn’t necessarily mean the portfolios are riskier because a lot of the low rated bonds are just legacy MBS that was downgraded following the crisis. Still, these funds should not be confused with the aggregate bond market. They are basically versions of a factor tilt.

This is important when you’re looking for attractive fixed income opportunities because many of these active fund managers are charging upwards of 1% for a fund that isn’t likely to return more than 2.5-4% in the coming years. So, if you can replicate the fund’s returns through an available low fee alternative then that’s something you’d be silly not to do. As I’ll describe below, that’s easier said than done in this space.