Steve Fleming
The US interest rate yield curve has moved into ‘inverse’ territory, causing concern among some fixed income investors – but not all.
Steve Fleming, Chief Executive Officer of Gryphon Capital Investments, said: “Our deep lens into the domestic mortgage landscape reveals certainty around borrower affordability and we see no reason why the RMBS and asset-backed securities (ABS) sector can’t continue to prosper in delivering the highest returns for the risks involved.
Mr Fleming explained that the interest rate yield curve is determined by the market as it weighs collective information to ‘bet’ what central banks will do next with their policy rates.
For example, he said, if the US Reserve Bank is forecast to raise rates to 2 per cent in 12 months’ time to counter inflation, then any fixed income investment earning less than that could be considered a poor investment. But if the US economy remains weak and the US central bank keeps rates near zero, then a 1.5 per cent yield would obviously remain attractive. RMBS are floating rate notes so the income they generate moves in line with interest rates.
Mr Fleming noted that at present, “US inflation is expected to rise rather than weaken and most central banks, in particular the US Federal Reserve, appear to be preparing to raise interest rates – and as a result bond yields are rising”. The US two-year bond yield has risen from 0.5 per cent in November to 2.3 per cent in March, while the 10-year rate has risen from 1.6 per cent to 2.3 per cent.
It is this fact that the 10-year rate is now less than the two-year rate that signals a flattening of the yield curve, to the point where the gap between these two rates recently moved to an inversion where the 10-year rate of return went below the two-year rate.
He said this yield curve inversion was often seen by the professional market as a leading indicator of recession, as it often has been accompanied by the US Federal Reserve initially raising interest rates quite aggressively, but then at some point stops and again begins to cut rates as they believe inflation is under control and that they need to prime the economy again as it is weakened somewhat from those higher interest rates; all the while creating uncertainty.
Mr Fleming noted: “In contrast, rates of combined residential mortgage-backed securities (RMBS) tend to follow the RBA cash rate and can also act quite differently in times of stress – such as inverse yield curves.
“They are 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. But the rate of return varies according to interest rates because RMBS are floating rate notes.”
Similarly, he noted that much had been made in the press of recent house price forecasts which indicate an expectation of slowing house price growth in Australia and even declines in house prices in 2023. “We do not see this as a major threat given the defensive nature of RMBS and it may even produce further buying opportunities, much as we saw at the time COVID broke out back in March 2020.”
What fixed income investors should do now
Mr Fleming suggested: “A key for fixed income investors today is to invest in credit that is linked to cash rates, such as RMBS that have a floating rate of interest that increases if rates go up.
“This is why it is important to invest with an established and credible credit manager.” He said 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 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 and now floods.
Conclusion
“Despite the global challenges, we believe that RMBS are better protected now from falls in house prices than they were prior to the pandemic, with many households having saved significantly during COVID,” said Mr Fleming.
“This market volatility is an external market factor unrelated to fundamental mortgage credit. 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.
“As a result, RMBS are the least sensitive to inverse yield curve or house price declines.”