Wednesday, July 15, 2015

FLASH UPDATE: Winter is coming. Keep returns warm in a rising rate environment

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