Here’s my logic, please let me know if I’m missing anything:
- Buying the Agencies gives a pretty nice positive arbitrage of over 2.2%, assuming the bonds are not called. Two percent of a California-size mortgage is very good money, and if it keeps up for 10 years is a windfall.
- If the bonds are called, it will likely be during a low interest rate environment. However, I can always use the bond proceeds to pay off the mortgage loan. So my “call option” on my mortgage offsets the risk of the Agency bonds being called away.
- The Agencies can be called starting in one year, so the shortest time to run the arbitrage would still give a return of 2.2% of principal– not too bad, and still probably worth the trade.
- There’s an additional tax play as, in California, the mortgage payments are deductible from state income, while the income from the FFCB bonds are not taxable.
There’s also a potential mismatch as the mortgage is amortizing and the bond isn’t. Using some kind of “Agency bond ladder” might get it closer, but that seems overly complicated. At the least I could buy Agencies in an amount needed to offset the unamortized portion of the mortgage in 10 years.
I don’t foresee the need to sell the Agency bonds, but if I had to for any reason they could book a loss. So you need to maintain plenty of liquidity to make this strategy work.
Assuming FFCB doesn’t default (and it is an implied Federal obligation), and I don’t need to sell the bonds, this seems like a pretty risk-free arbitrage. What am I missing?