26
Sep
2020
Rates have dropped precipitously across the board from the start of the year by 145 basis points (“bps”) on the short end to 90 bps on the long end. Performance of the TLT (20+year Treasury) is +20.6% YTD. What this has created, however is a quandary for fixed income investors.
Interest Rate Curves, 1/1/2020 – 08/28/2020:
Historical reasons to own fixed income:
We strive to answer the last question here.
Below is a portfolio of treasuries that closely match the Bloomberg / Barclays Treasury Aggregate Index, with a duration of roughly 7.1 years.
When your starting yield was 5% (think 2007), and the Fed had room to lower rates, you had 36% of upside in your bond portfolio. In a traditional 60/40 portfolio, this protected you against a 24% decline in your equity portfolio. Even at the start of this year, when the yield was close to 2%, you had 14% of upside in your bond portfolio and thus protection against roughly a 9% decline in equities. Today, your bond holdings only provide 3.9% upside to a zero bound interest rate, protecting only 2.6% of equity drawdowns.
If you’re only getting 0.53% of income and you have almost no protection against equity drawdowns, what’s the point of holding treasuries? If you’re holding investment grade corporates or municipal bonds, the picture is even worse. Why is that?
77% of the entire corporate and municipal investment grade fixed income universe is trading over par ($100). When you buy a 4% coupon bond at $100 and interest rates decrease, the value of your bond increases and thus the price goes up. After a certain amount of time, the corporation or municipality has the option to call your bond and pay you $100 back so that they can re-issue bonds again at $100, but at a lower coupon. This creates what’s called negative convexity in bonds. If interest rates go down, the price of your bond goes up, but not as much as a US Treasury would, because most bonds are callable at $100 and thus the likelihood that your bond gets called increases. Conversely, if interest rates go up, and people can go out and purchase new issue bonds at higher yields, the price and value of your bond decreases.
Back to treasuries. There is most definitely a need for some institutions to hold treasuries. Banks, insurance companies, pensions, etc. NEED liquidity and are driven by defined liabilities that they need to pay off. Institutions that are seeking income and or a hedge to their equity exposure, must now search elsewhere.
A large swath of the non-agency RMBS universe combats the negative convexity problem as much of this universe trades at a discount to par. Prepayments, called securities, rising rates are almost all universally good for non-agency RMBS. Furthermore, you can achieve 4-5% in income as evidenced by our current book yield. We believe these to be a good replacement for corporate and municipal securities that have run their course in terms of equity hedging and income production.
If you’d like a copy of this sheet, to measure your fixed income portfolio’s ability to hedge, please let us know.
Let’s also look at the health of the consumer and how it has been relating to housing as well.
The BLS reported unemployment rate stands at 10.2%, however, the number as reported by states sums up to 17.5%! A huge difference. We can see this continuing to affect sectors of the economy that are consumer facing. Housing, on the other hand has been extremely strong.
Housing Starts: Huge Bounce Back
Existing Home Sales: Ditto!
Housing Affordability, Best in 5 Years
Home Price Index, +3.46% YOY
It’s a good time to be long housing and long mortgage-debt. We feel this sector will continue to provide outsized income versus other fixed income products.
We’re launching a mutual fund, Regan Total Return Income Fund, on October 1, 2020. Please reach out to ir@regancapital.com for details.
It’s incredibly difficult to get any semblance of return in fixed income. Safe corporate and municipal bonds yield less than 1%. Short duration bond funds yield 0-2%. The dividend yield on the S&P is sub 2%. We’re aiming to combat these issues with the launch of our mutual fund.
Our aim is to provide liquid access to both the income and capital appreciation that come from the RMBS market.
We hope that adding the mutual fund to our product offering will add significant value to individuals and institutions that need yield but also need daily liquidity or are unable to write $20+mm checks to do a separately managed account. As a business, launching a mutual fund will allow us to continue to serve a greater number of clients, grow and support our business, while keeping the partnerships at a size that will allow them to be more nimble, opportunistic, and alpha-seeking.
As always, please reach out if we can answer any questions or be of service.
We have appended some charts and commentary to this letter. On the non-agency side, we’ll cover spreads, performance, and issuance. On the agency side, we’ll cover rates, issuance, affordability, spreads, and our view on when/if agencies are an attractive sector versus non-agency.
The main theme in the agency mortgage market for the past few months has been lower rates and a continued pickup in mortgage prepayments driven by increased refinance activity. 30-year mortgage rates hit an all-time low earlier this month with 30-year mortgage rates hitting 2.88%. The Federal Reserve has also played its part in keeping mortgage rates low with purchasing approximately $40 billion a month of agency MBS. Despite this move lower in mortgage rates, agency mortgages offer better duration adjusted yield versus government bonds. Looking below, over the past 3 years we can see that the spread of mortgage yield over treasury bond yield has been trending up, and currently offers over +100 bps of additional yield.
Within the agency mortgage universe, we have significantly decreased our portfolio of Interest-Only product over the last 6-9 months. When interest rates started dropping more in 2018, we saw there being more risk than reward in the sector, and we decreased the allocation and have continued to trim it. It is currently near 5% down from 30%. Looking below, it is evident that all time low mortgage rates are driving robust turnover in the mortgage market as borrowers refinance. On top of that, the added federal reserve buying of agency MBS each month also supports and will continue to support low mortgage rates. As a result, we see several more months ahead of elevated mortgage prepayment speeds. We just don’t want to be making bets on Interest Only product that only benefits from a slow-down in prepayments where the mortgage principal stays outstanding for a longer period of time. We will keep an eye on this space to see if opportunities present themselves as this refinance wave slows down months down the road.
Below see aggregate FNMA CPR historical data back to 2004. CPR is a measure of the prepayment rate of the outstanding mortgage principal being paid off. The recent pick up in prepayment rates is very evident.
See below for historical 30-year mortgage rates. A low of 2.88% was hit earlier this month.
Finally, below shows the amount of agency mortgage backed securities the Federal Reserve has bought plus commitments to buy/sell in billions (almost hold currently about $2 trillion). The recent upward trend this year makes it clear how committed they are to supporting this market and lower rates in the near term.
