Investors concerned by reduced returns from fixed income investments should look to invest in credit products that are linked to cash rates to take advantage of potential future rate rises, according to an Australian specialist fixed income manager.
Gryphon Capital Investments chief executive Steve Fleming said inflation in the United States was expected to increase and many central banks, including the US Federal Reserve, were preparing to lift interest rates and bond yields were rising.
He noted the US two-year bond yield had risen from 0.5 per cent in November 2021 to 2.3 per cent in March 2022, while the 10-year rate had increased from 1.6 per cent to 2.3 per cent, and the closing of the gap between these two will result in a flattening of the yield curve and inversion will likely lead to zero or negative returns.
“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,” Fleming explained.
He pointed out RMBS were attractive in the current environment as they typically follow the Reserve Bank of Australia cash rate and act differently in times of stress, including during inverse yield curves.
“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,” he said.
“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.”
He acknowledged while there was an expectation of slowing house price growth in Australia, RMBS investments were less likely to be impacted by these events.
“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,” Fleming 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 sector can’t continue to prosper in delivering the highest returns for the risks involved.”
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