Some financial advisers (and investors) have never known an inflationary environment – what do they need to know?

From

Ashley Burtenshaw

With the last Reserve Bank of Australia (RBA) rate rise over 11 years ago, there are some financial advisers who have never known an inflationary environment. 

This could make it hard for some to advise their investor clients on how to obtain reliable and consistent income with defensive characteristics in today’s rising interest rate environment.

A key for fixed income investors today is to invest in credit that is linked to cash rates, such as residential mortgage-backed securities (RMBS) that have a floating rate of interest that increases if rates go up,” suggested Ashley Burtenshaw, co-founder and Chief Investment Officer at Gryphon Capital Investments. 

“For example, rates of combined RMBS tend to follow the RBA cash rate,” he said.

“They are also often seen as a safer haven asset and can help cushion a portfolio that may be too heavy on equities.”

“The reason is that RMBS are an investment similar to a bond but are made up of a bundle of home loans bought from the banks that issued them. Investors in RMBS receive periodic payments similar to bond coupon payments.”

RMBS offer an advantage over bonds as while they are similar in structure they are floating rate notes.”

“This means that the income investors receive from an RMBS investment increases as interest rates increase.”

Mr Burtenshaw suggested younger financial advisers learn more about RMBS and ABS as sources of income for their income-focused clients.

“For instance, not all advisers realise “RMBS sit high in the capital structure and consequently issuers are required to pay these obligations in full ahead of senior unsecured bank debt, hybrids or dividends, providing additional security. RMBS issuers must pay their RMBS obligations in full prior to being able to allocate cash (profits) to pay anything else such as senior unsecured bank debt, hybrids, or dividends.”

“Our in-depth and specialist focus on the domestic mortgage landscape reveals a level of certainty around borrower affordability and we see no reason why RMBS can’t continue to prosper in delivering the highest comparative returns for the risks involved for income investors.”

He also added that it was important to invest with an established and credible credit manager and that Gryphon Capital were big believers in reliable and consistent income for investors. “Gryphon was established to be the most advanced investor in our asset class with a philosophy built around the use of extensive data to drive investment decisions and provide transparency to income investors.”

Gryphon has been tactically positioning all its portfolios with a strong defensive bias. This was in anticipation of a weaker investment environment including elevated market volatility. Escalating geopolitical tensions culminating in Russia’s invasion of Ukraine have also compounded an already fragile market facing reduction in central bank liquidity, inflation and uncertainty regarding the pace and timing of interest rate increases. In Australia, add to all that moderating house prices.

Mr Burtenshaw noted the average Australian home loan payee is 2.1 years ahead of their mortgage payments*. “This means that they could miss over two years of mortgage payments and still be current with their mortgage.”

The RBA’s own Financial Stability Review (FSR) released in April 2022 shows that it was very focused on the impact of rate rises on the housing market. The report notes that most borrowers are well positioned to weather rate increases having built up substantial overpayments on their loans during the pandemic, citing “strength in household balance sheets has been underpinned by high savings, the strong labour market and rising house prices”.

“As a result,” Mr Burtenshaw said: “we believe RMBS are one of the least sensitive fixed income investments to interest rate rises and potential house price declines.”

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