3 Funds for Operation Twist

10/13/2011 8:30 am EST

Focus: FUNDS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Whether the Federal Reserve’s newest gambit works or not is a moot point, since there’s always a way to profit from it, writes Benjamin Shepherd of Personal Finance.

The Federal Open Market Committee recently unveiled Operation Twist, a reprise of a 1960s program designed to push down long-term interest rates.

Under the program, the Federal Reserve will sell $400 billion of Treasury securities with remaining maturities of three years or less, and roll the proceeds into Treasuries with maturities of at least six years.

The central bank will also reinvest principal payments from the roughly $1 trillion worth of mortgage debt on its balance sheet into additional mortgage-backed bonds issued by government-related entities.

Many have greeted the Fed’s plan with skepticism. Interest rates hovered near a record low for almost three years, but reduced borrowing costs haven’t stimulated loan demand.

Nevertheless, Operation Twist will benefit a few key bond holdings.

Fidelity GNMA (FGMNX) has rallied in the back half of 2011 after it became clear that the weak economic recovery would force the Fed to hold its mortgage-backed bonds for some time. Operation Twist should put a floor under the price of these bonds for at least the next several months.

Fidelity Floating Rate High Income (FFRHX), which invests in floating-rate bank loans whose interest rates reset on a quarterly basis, should also receive a boost from the Fed’s efforts.

The central bank’s plan to sell debt with short maturities should push up short-term interest rates, which should marginally increase the interest rates charged on bank loans in the fourth quarter. This should boost the fund’s 3.5% yield incrementally and won’t meaningfully affect the loans’ market value.

Fidelity GNMA and Fidelity Floating Rate High Income continue to rate a buy at current prices.

However, Operation Twist won’t affect SPDR DB International Government TIPS (WIP) because the program is balance-sheet neutral and unlikely to stoke inflation—particularly if the Fed’s bond purchases fail to stimulate borrowing. With the major developed-world economies mired in slow growth, global inflation should remain subdued in the near term.

Despite this favorable inflationary outlook, SPDR DB International Government TIPS remains an attractive long-term hedge against future increases in consumer prices.

A great deal of artificial liquidity continues to course through the global financial system. Given the weakness of the economic recovery, monetary authorities will likely be loath to remove this liquidity for some time. SPDR DB International Government TIPS remains a buy at current prices.

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