Tag Archives: yield curves

UPDATE: Profiting From A Steepening Yield Curve

In June we wrote an RIA Pro article entitled Profiting From A Steepening Yield Curve, in which we discussed the opportunity to profit from a steepening yield curve with specific investments in mortgage REITs. We backed up our words by purchasing AGNC, NLY, and REM for RIA Advisor clients. The same trades were shared with RIA Pro subscribers and can be viewed in the RIA Pro Portfolios under the Portfolio tab.

We knew when we published the article and placed the trades that the short term risk to our investment thesis was, and still is, a further flattening and even an inversion of the yield curve. That is precisely what happened. In mid to late August the curve inverted by four basis points but has since widened back out.

The graph below compares the 2s/10s yield curve (blue) with AGNC (orange) and NLY (green). Beneath the graph is two smaller graphs showing the rolling 20-day correlation between AGNC and NLY versus the yield curve.

Since writing the article and purchasing the shares, the securities have fallen by about 5%, although much of the price loss is offset by double digit dividends (AGNC 13.20%, NLY 10.73%, and REM 9.06%). While we are not happy with even a small loss, we are emboldened by the strong correlation between the share prices and the yield curve. The trade is largely a yield curve bet, so it is comforting to see the securities tracking the yield curve so closely.

We still think the yield curve will steepen significantly. In our opinion, this will likely occur as slowing growth will prompt the Fed to be more aggressive than their current posture. We also think that there is a high probability that when the Fed decides to become more aggressive they will reduce rates at a faster clip than the market thinks. As we discussed in Investors Are Grossly Underestimating the Fed, when the Fed is actively raising or reducing rates, the market underestimates that path.

To wit:  If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?”

Bolstering our view for a steeper yield curve is that the Fed, first and foremost, is concerned with the financial health of its member banks. The Fed will fight an inverted yield curve because it hurts banks profit margins and therefore reduces their ability to lend money. Because of this and regardless of the economic climate, the Fed will use words and monetary policy actions to promote a steeper yield curve.

We are very comfortable with the premise behind our trades, and in fact in mid-August we doubled our position in AGNC. We will also likely add to NLY soon.

For more on this investment thesis, please watch the following Real Vision interview Steepening Yield Curve Could Yield Generational Opportunities.

Profiting From A Steepening Yield Curve

What is the yield curve and what does it mean for the economy and the markets?

Over the last few months, the financial media has obsessed on those questions. Given the yield curve’s importance, especially considering the large amount of debt being carried by individuals, corporations, and the government, we do not blame them. In fact, we have given our two cents quite a few times on what a flattening and inversion of various yield curves may be signaling. Taking our analysis a step further, we now look at investment ideas designed to take advantage of expected changes in the yield curve.

An inversion of the 2yr/10yr Treasury yield curve, where yields on 10-year Treasury notes are lower than those of 2-year Notes, has accurately predicted the last five recessions. This makes yield curve signaling significant, especially now. It is important to note that in the five prior instances of yield curve inversions, the recession actually started when, or shortly after, the yield curve started to steepen to a more normal positive slope following the inversion. In our opinion, the steepening, and not the flattening or inversion of the curve, is the recession indicator.  

As discussed in Yesterday’s Perfect Recession Warning May Be Failing You, we believe the 2yr/10yr curve may not invert before the next recession. It may have already troughed at a mere 0.11 basis points on December 19, 2018. If we are correct, the only recession warning investors will get could be the aforementioned curve steepening. Another widely followed curve spread, the yield difference between 3-month Treasury bills and 10-year Treasury notes, recently inverted and troughed at -25 basis points, which makes the likelihood of a near-term recession significant.

The remainder of this article focuses on REITs (real-estate investment trusts). Within this sector lies an opportunity that should benefit if the yield curve steepens, which we noted has occurred after an initial curve inversion and just before the onset of the last five recessions.  

What is an Agency Mortgage REIT?

REITs are companies that own income-producing real estate and/or the debt backing real estate. REITs tend to pay higher than normal dividends as they are legally required to pay out at least 90% of their taxable profits to shareholders annually. Therefore, ownership of REIT common equity requires that investors analyze the underlying assets and liabilities of the REIT to assess the potential flow of income, and thus dividends, in the future.  

The most popular types of REITs are called equity REITs. These REITs own equity in apartments and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREITs), which own the debt (mortgages) on real-estate properties. Within this sector is a subset known as Agency mREITs (AmREITs) that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

From an investor’s point of view, a key distinguishing characteristic between equity REITs and mREITs is their risk profiles.  The shareholders of equity REITs are chiefly concerned with vacancy rates, rental rates, and property values.  Most mREIT shareholders, on the other hand, worry about credit risk and interest rate risk. Interest risk is the yield spread between borrowing rates and the return on assets. AmREITS that solely own agency guaranteed mortgages assume no credit risk as timely payment of principal and interest is advanced by the security issuer (again either Fannie Mae, Freddie Mac, or Ginnie Mae, all of whom are essentially government guaranteed). Therefore, returns on AmREITs are heavily influenced by interest rate risk. Almost all REITs employ leverage, which enhances returns but adds another layer of risk.

Agency mREITs

Earnings for AmREITs are primarily the product of two sources; the amount of net income (yield on mortgages they hold less the cost of debt and hedging) and the amount of leverage.

A typical AmREIT is funded with equity financing and debt. The capital is used to purchase government-guaranteed mortgages. Debt funding allows them to leverage equity. For example, if a REIT bought $5 of assets with $1 of equity capital and $4 of debt, they would be considered 5x leveraged (5/1). Leverage is one way REITs enhance returns.

The second common way they enhance returns is to run a duration gap. A duration gap means the REIT is borrowing in shorter maturities and investing in long maturities. A 2-year duration gap implies the REIT has an average duration of their liabilities that is two years less than the duration of their assets. To better manage the duration gap and the associated risks, REIT portfolio managers hedge their portfolios. 

The Fed’s Next Move and AmREITs

With that bit of knowledge, now consider the Fed’s quickly changing policy stance, how the yield curve might perform going forward, and the potential impact on REITs.

Recent speeches from various Fed members including Chairman Powell and Vice Chairman Clarida are leading us and most market participants to believe the Fed could lower rates as early as the July 31st FOMC meeting. Most often, yield curves steepen when, or shortly before, the Fed starts lowering rates. While still too early to declare that the yield curve has troughed, it has risen meaningfully from recent lows and is now the steepest it has been since November of 2018.  

If we are correct that the Fed reduces the Fed Funds rate and the yield curve steepens, then AmREITs should benefit as their borrowing costs fall more than the yields of their assets. Further, if convinced of a steepening event, portfolio managers might reduce their hedging activity to further boost income. The book value of AmREITs have a strong positive correlation with the yield curve, and as a result, the book value per share of AmREITs should increase as the curve steepens.

The following two graphs compare the shape of the 2yr/10yr yield curve versus the book value per share for the two largest AmREITs, Annaly Capital Management (NLY) and AGNC Investment Corporation (AGNC). The third and fourth graphs below show the same data in scatter plots to appreciate the correlation better. The current level of book value per share and yield curve is represented by the orange blocks in each scatter plot. Statistically speaking, a one percent steepening of the yield curve should increase the book value per share by approximately $2 for both stocks. Given both stocks have dividend yields in the low double-digits, any book value appreciation that results in price appreciation would make a good return, great.

Data Courtesy Bloomberg

While a steepening yield curve will likely create more spread income and thus a higher book value for these REITs, we must also consider the role of leverage and the premium or discount to book value that investors are currently paying.  

  • NLY is employing 8.2x leverage, which is slightly higher than their average of 7.6x since 2010, but less than their 20+ year average of 9.94.
  • AGNC uses more leverage at 10.2x, which is higher than their average of 8.8x since 2010. The REIT was formed in late 2008, therefore we do not have as much data as NLY. 
  • NLY trades at a discounted price to book value of .94, slightly below their historical average
  • AGNC also trades at a discounted level of .92 and below their historical average.

The risks of buying AGNC or NLY are numerous.

  • We may be wrong about the timing of rate cuts and the curve may continue to invert, which would decrease book value. In such a case, we may see the book value decline, and potentially even more damaging, the discount to book value decreases further, harming shareholders.
  • Even if we are right and the yield curve steepens and the REITs asset/liability spreads widen, we run the risk that investors are nervous about real-estate going into recession and REITs trade to deeper discounts to book value and effectively offset any price appreciation due to the increase in book value.
  • Leverage is easy to maintain when markets are liquid; however, as we saw a decade ago, REITs were forced to sell assets and reduce leverage which can also negatively affect earnings and dividends. It is worth noting that NLY had an average of 12.90x leverage in 2007, which is significantly larger than their current 8.20x.

Summary

Despite double-digit dividend yields and the cushion such high dividends provide, buying NLY or AGNC is not a guaranteed home run. The two REITs introduce numerous risks as mentioned.  That said, these firms and other smaller AmREITs, offer investors a way to take advantage of a steepening yield curve while avoiding an earnings slowdown that may hamper many stocks in an economic downturn.

While NLY and AGNC are in the same industry, they use different portfolio tactics to express their views. As such, if you are interested in the sector, we recommend diversifying among these two companies and others to help reduce idiosyncratic portfolio risks. We also recommend investors assess the IShares Mortgage Real ETF (REM). Its two largest holdings, accounting for over 25% of the ETF, are NLY and AGNC.  It is worth noting however, this ETF introduces risks not found in the AmREITs. The ETF holds the shares of mortgage REITs that contain non-guaranteed mortgages as well as mortgages on commercial properties.

Quick Take: The Treasury Bill Yield Curve Says A Recession Is Imminent

We have discussed yield curves in quite a few commentaries and articles over the last few months. The reason we stress the topic is that yield curve inversions are not only uncommon, but their occurrence is highly correlated with recessions.

Typically, when people use the phrase “the yield curve,” they are referring to the 10 year/2 year Treasury curve spread. While that curve is important, there are other curves that are predictive of future Fed rate policy as well as the prospects of a coming recession.

For example, the graph below shows the 6month/3month Treasury bill curve. Because the maturities making up this curve are so short, its usefulness is in providing an outlook for what the Fed might do and how soon they might do it.

As shown above, the 6m/3m curve now sits at negative 13 basis points, meaning 6 month T-bills now yield .13% less than 3 month T-bills. The 3 month bill is currently priced at a yield of 2.26 which is about 14 basis points below where it traded earlier this year prior to when the market thought the Fed would ease in 2019.  

Given the yield decline, the timing of the Fed’s meetings, and the term to maturity, the current 3 month bill implies nearly a 100% chance that the Fed will reduce rates by 25 basis points at the July 31st meeting. The yield on the 6 month bill implies the same rate cut plus a 50% chance of another rate cut at the September 18th meeting which is the next meeting after the July 31st meeting.

Essentially the graph highlights that the last two recessions occurred shortly before or after the T-bill market implied a greater than 50% chance of consecutive rate cuts by the Fed, as it is now.

The bond markets for the moment are signaling that a recession is imminent as the chances of Fed rate cuts becomes more likely by the day. At the same time, the stock market appears to think that easier Fed policy will protect the value of the stock market. Based on historical precedence and current valuations in stocks and bonds, we would argue they cannot both be right.

Six of the last seven times the Fed has lowered rates a recession followed. August of 1998, the one instance it did not occur, was Fed action to minimize the effect of the failure of Long Term Capital Management, one of the world’s largest hedge funds at the time. It is worth noting, their actions, along with Y2K spending, likely forestalled the recession which followed two years later. 

The table below shows the previous seven times the Fed reduced rates by 75 basis points or more and the maximum drawdowns that occurred in the S&P 500 over various time frames.  Needless to say, heed the message of the bond market and trade with care.