Given the imminence of a rate
normalization cycle, many investors are preoccupied with the notion that
traditional fixed income investments, such as Treasuries, will lose value as
rates increase. Such assets will likely decline in value as the coupons of the
securities will be below market coupons. In fixed income, we refer to this
concept as positive duration. As such, many investors have shied away from an
asset class that is abundant with opportunity. An astute investor may short
traditional fixed income securities to generate positive return as rates rise.
While such a strategy should benefit from a rising rate environment,
there is a limit to the benefit as the cash flows of traditional fixed income
assets are fixed. Moreover, this strategy has negative carry due to owing
coupon income and the cost of borrowing. We have found that certain classes
of Mortgage-Backed-Securities, such as Interest Only Securities, often offer
the most attractive return in a rising rate environment as their valuations
rise and expected cash flows increase.
The chart above shows the theoretical
total return – price appreciation and net carry – of the aforementioned
strategies, assuming the yield curve follows the Fed’s ‘Dot Plot’ in a linear
fashion through December 2017. For simplicity, we assumed spreads on the IO securities
remain constant. While the short Treasury position appears attractive, the
returns are dwarfed by those of the IO due to the increase in cash flow earned
over the life of the IO. Given the imminence of rising rates, we feel this
is an opportune time to invest in IO securities as they offer attractive carry
and are expected to increase in value in rising rate environments.
Regards,
Tradex Global Advisory Services, LLC
investorrelations@thetradexgroup.com
203-863-1500
@Tradex_Global
