When the Fed Is the Risk: Mortgages in a Risk-Reducing Core Portfolio

In our November 2025 note, Mitigating Risk in a Bond Portfolio, we focused on how to think about valuations across credit. This piece is meant as a companion, looking at a narrower question: what kind of interest-rate risk should sit at the heart of a “core” portfolio when Fed independence itself is in play?

Fed independence as a macro risk factor

The US Federal Reserve is facing an unusual level of political pressure. A high-profile criminal investigation into Chair Jerome Powell’s handling of the Fed’s building renovation has drawn explicit statements of support for Powell from global central banks and raised public concerns about Fed independence.

For bond investors, the key point is not the headline drama but what it implies for the range of policy outcomes. When independence is questioned, markets have to consider a wider set of scenarios such as:

·         The Fed cuts more quickly or aggressively than the data alone would warrant.

·         Or, it stays tighter for longer to demonstrate its autonomy.

Even if the average path of policy and inflation ends up close to today’s projections, the uncertainty experienced along the way increases. That is another way of saying interest-rate volatility should be higher in a world where the Fed’s reaction function can no longer be taken for granted.

Core’s Complex Risk

Within the Bloomberg US Aggregate Index, agency mortgage-backed securities (MBS) remain the second-largest sector after Treasuries at 24.6% of the benchmark as if 12/31/25. That means most traditional “core” mandates still carry a meaningful mortgage allocation, even if they are only matching the index.

Mortgages are unusual because they embed an investor-unfriendly option. When rates fall, borrowers refinance; when rates rise, they tend to stay put. From an investor’s perspective:

·         Fed cuts too fast: policy rates drop, the market starts to price a lower path for long rates, and mortgage rates move down. Refinancing picks up and prepayments accelerate. Prices on existing MBS do not rally like long Treasuries because the cash flows shorten and the best coupons get called away.

·         Fed stays too tight: policy rates stay higher, markets keep term premia elevated, and mortgage rates stay sticky at higher levels. Prepayments slow and durations extend. MBS cheapen as investors demand more spread to own longer, more uncertain cashflows.

These scenarios highlight the “negative convexity” associated with MBS. The more policy error and political noise there is, the more negatively convex structures become misaligned with what allocators actually want core bonds to do: smooth the ride for clients.

Designing a risk-reducing core sleeve

The implication is not that agency mortgages are “bad” assets, nor that they have no role to play. It is that, in this regime, they should be a deliberate choice, not a default allocation held just to match a large index position.

We believe a risk-reducing approach to core fixed income in 2026 should stay focused on:

·         Transparent, option-free duration – Treasuries and high-quality, low-optionality bonds as the primary tool for offsetting equity and credit shocks in a world of fatter policy tails.

·         Measured, valuation-aware mortgage exposure - agency MBS sized with an explicit view on rate volatility, rather than simply mirroring the index.

·         Consistency with the valuation discipline concepts highlighted in Mitigating Risk in a Bond Portfolio – the same principles (clarity on what risks you are paid to take, and how each sector behaves under stress) applied not just to credit, but to rate risk itself.

For advisors and their clients, the communication can be simple:  In an environment where the Fed’s independence is contested and rate paths are less predictable, we want our “core” bond sleeve to take simple, linear rate risk on purpose, and to take complex, option-driven risk only when the compensation is clear.

At Curasset, that means structuring our core strategies around clean duration and disciplined credit, with a significant underweight to agency mortgages given our outlook for higher interest rate volatility. If the Fed navigates this period smoothly, that mix should still deliver stable results.  If policy is buffeted by politics, it is the kind of core fixed income that is better positioned to serve its protective function in broader asset allocations.