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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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.”

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Ashley Burtenshaw

Gryphon Capital Income Trust (GCI or Fund) has commenced trading on the ASX, under the code GCI. This follows a successful and comprehensive roadshow process which raised $175.3m.

Ashley Burtenshaw, co-founder and Chief Investment Officer of GCI, said “The ability to achieve diversification within a fixed income portfolio and receive a monthly income stream resonated strongly with investors.

“This type of exposure plays an important defensive role in a portfolio, as it is not correlated to traditional asset classes such as equities.

The Listed Investment Trust provides a unique opportunity for investors to access a portfolio of Residential Mortgage Backed Securities (RMBS) and Asset Backed Securities (ABS) in an ASX listed vehicle managed by a specialist fixed income asset manager that manages $1.7bn on behalf of institutional investors.

RMBS and ABS have a number of important structural protections that mitigate the risk of bondholders taking a principal loss. These credit enhancements include borrower’s equity, lenders mortgage insurance, originators excess interest and originators first loss.

Every proposed RMBS investment is stress tested to withstand the APRA stress scenarios that are used by Lenders Mortgage Insurers in calculating Probable Maximum Loss which corresponds to a 1 in 200 year event, prior to consideration for the portfolio.

Morgans and NAB were Joint Arrangers and Lead Managers to the transaction.

Chris Donohoe, Partner at Seed Partnerships, advisors to GCI said: “We are really pleased to be able to bring a listed investment trust to investors that offers exposure to an alternative fixed income strategy. The quality of the investment managers, the robustness of their processes and track record, made this a very compelling offer and contributed to this excellent result.”

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The Fund has a current target return of 5% per annum, equivalent to the RBA cash rate plus 3.5%; distributions will be floating rate and paid monthly.

GCIT provides a unique opportunity for investors to access a portfolio of secured wholesale bonds in an ASX listed vehicle managed by a specialist fund manager. The Fund fills a gap in the market for stable monthly income whilst preserving capital through a combination of portfolio diversification and more importantly secured debt securities.  Specifically, investors will for the first time have direct access to Residential Mortgage Backed Securities (RMBS) and Asset Backed Securities (ABS), markets that have been solely the preserve of institutional investors in Australia.

The Fund’s strategy will combine the disciplines and processes of two of GCI’s existing institutional funds. Secured Opportunities (commenced April 2015) and Investment Grade Securitised (commenced September 2016) strategies managed for wholesale investors that have returned 6.93% and 5.31% net of fees per annum respectively since inception.

Joint Arrangers and Lead Managers to the transaction Morgans and NAB, believe that GCI’s strong track record and deep experience in this specialist fixed income sector, make this a compelling offer for investors looking to increase portfolio diversification. The long term support of their institutional clients is testament to GCI’s expertise and track record of delivering capital stability as well as stable and predictable returns. We are pleased to now have the opportunity to provide retail investors with access to this specialist investment manager and strategy.

Ashley Burtenshaw, co-founder and Chief Investment Officer of GCI, said “Australian investor portfolios are overweight cash having gravitated towards stable bank deposits that provide low returns as a result of the record low RBA cash rate. We are pleased to provide investors with a stable alternative,that  provides both capital protection, through investment in a diversified portfolio of asset backed securities, along with a strong targeted monthly income.”

Details of the Offer

The Responsible Entity, on behalf of the Fund, is offering up to 175 million new units at $2.00 per unit, to raise $350 million (Offer). The minimum subscription is $100 million.

Gryphon Group will pay the costs of the offer such that the net asset value of each unit at listing is equivalent to the application price of $2.00 per unit.

To participate in the Offer

The Offer is being made under a product disclosure statement lodged with ASIC on 6 March 2018 (PDS) and is available on the Fund’s website www.gcapinvest.com/GCI. Applications under the general Offer can be made by completing the application form attached to the PDS or online through the application form accompanying the electronic PDS. Applicants under the broker firm Offer should contact their broker for application details.

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