Mortgages, the Bond Market, and Mortgage-Backed Bonds
In the latest episode of the Wealthy Behavior podcast, I talk to Ken Shinoda, a portfolio manager with DoubleLine Capital and head of their mortgage-backed securities team about the current bond market, mortgage-backed securities, and mortgage rates. We dig into:
- Opportunities and risks in today’s mortgage-backed securities market
- Where interest rates might be going in the next few months and next few years
- How mortgage rates are set and when they may drop
- What the bond market says about the economy now
- Why commingled vehicles are more efficient than buying individual bonds
- Why active bond management makes sense
Listen through the end as Bob Weisse, Chief Investment Officer at Heritage Financial, joins to help dissect the topic and how investors should be thinking about it.
We’d love to hear from you! Email us questions, ideas, or feedback at wealthybehavior@heritagefinancial.net.
Edited transcript below.
A Primer on Mortgage-Backed Securities
Available through the link in title and wherever you get your podcasts
Transcript
Welcome to Wealthy Behavior, talking money and wealth with Heritage Financial, the podcast that digs into the topics, strategies and behaviors that help busy and successful people build and protect their personal wealth. I’m your host, Sammy Azzouz, the president and CEO of Heritage Financial, a Boston based wealth management firm working with high net worth families across the country for longer than 25 years. Now let’s talk about the wealthy behaviors that are key to a rich life.
00:00:06 – 00:05:03
On this episode of the Wealthy Behavior podcast, we have a special guest, Ken Shinoda, portfolio manager at Double Line Capital, where he manages and co-manages several fixed income strategies, as well as overseeing the team investing in non-agency backed mortgage securities. I can think of few people who would be better to speak with at a moment in time like this for the market, just given the sharp moves we’ve had in interest rates, which have impacted bonds and stocks, and mortgage rates being higher than we’ve seen in a long time. And be sure to stick to the end as I digest this conversation with our Chief Investment officer, Bob Weisse, and share his key takeaways as well.
I’m excited for this conversation, so welcome to Wealthy Behavior, Ken.
Thanks for having me.
Appreciate it. Absolutely. Could you provide our listeners maybe with a brief overview of Double Line and your role with the firm?
Absolutely. Double Line is a Los Angeles based asset manager. We predominantly manage fixed income, but we also have some passive smart beta equity strategies that have done quite well. We have a commodity strategy, but I would say about 90 % of our assets are fixed income based with a heavy tilt towards securitized products, which are things like mortgage backed securities, asset backed securities, collateralized loan obligations. We have about 95 billion under management.
And what is your role specifically with the firm? I know I mentioned the bio, but how would you explain that to listeners?
Yeah, I am a portfolio manager across a variety of our products, especially those that are more focused on mortgage backed securities. I also have the structured products committee, which oversees the asset allocation process on our securitized focused strategies.
How did you get started on this career path? How did you get to this point?
I wanted to get into something real estate related coming out of school. I had a couple of interviews. I actually was interning at Trust Company West TCW, which where many of the Double Line employees came from and just happened to stumble onto this role. I didn’t come out of school thinking, hey, I want to trade mortgage backed securities. It wasn’t really something that was pushed on the West Coast. I think East Coast schools are more investment banking trading focused. So, luck happens. Pretty big asset management community out in the West Coast with a pretty big presence, especially in Southern California with PIMCO, WAMCO, Capital Group out here. So there’s actually a pretty big fixed income focus, at least in the Southern California area.
Great. And we’ve talked a couple of times already about mortgage backed securities. How would you explain those to listeners or maybe people who’ve read The Big Short and have some misconceptions about what they are and how risky they could be?
If you go back a long, long, long time ago before we created the government sponsored entities, Fannie, Freddie and Ginnie Mae mortgages, if you went to a bank to get a mortgage, it was always going to be floating rate, an adjustable rate mortgage because the banks didn’t want to take on such a long duration risk. And what happened was Fannie and Freddie and Ginnie Mae were put into place to try to get the cost of debt down for Americans to buy homes and a goal to increase home ownership or help more people get into homes. And they introduced the 30 year fixed rate mortgage and then they would package up those mortgages eventually and create bonds backed by these mortgages. So you can basically buy a bond that’s government guaranteed, that’s whose cash flows come from these mortgage backed securities. And so instead of taking on credit risk, what you’re really taking on is prepayment risk. If rates go down, borrowers have the ability to refinance without any cost really. And if rates go higher, then the refinancing activity slows down. So you have this kind of like uncertainty of how long your investment is. Is it a one year bond or is it a 10 year bond? It all depends on the prepayments through time. So instead of sitting around and worrying about credit risk and default risk, you’re really sitting around and worrying about the direction of rates and what that means for refinancing activity.
And so the direction of rates is a great place to go. You’ve been doing this for a while. How would you characterize the investment environment, the interest rate environment that we’re in right now?
Well, it’s been the worst interest rate environment that I’ve seen from a sharp movement and rates higher. I mean, we’ve been in a bond bear market now for three years, the 10 year yield on a closing basis.
00:05:03 – 00:10:10
The low was in August of 2020. Intraday, we were a little bit lower in March during kind of the fiasco when the shutdown started. And we’ve reached new highs in August across the curve really. So it’s been a really tough market. Part of it’s been driven by the Fed with their reaction to high inflation. And we’ve seen a pretty dramatic increase in short term rates and the long end has fallen. And we have a little rally as there was hopes and glimmers of a soft landing and data rolling over. But what we have now is the soft landing narrative is still there, but the data’s coming in better than expected. So I think a couple of prints, the GDP print came in strong, you had services coming strong, you had some jobs that are still coming in strong. And so the whole curve has kind of shifted back up with the market now thinking the Fed may still have more to do. And if they don’t have more than one hike, they’re at least going to keep rates higher for longer. And if the economy is strong, then why should long term rates be so low? Maybe they should normalize up towards, let’s say, four and a half, five percent on the 10 year. So that’s kind of what’s happened, I think over the last 30 days is the narrative has shifted from kind of this expectations of growth rolling over to, you know, perhaps growth is better than expected. And now the market’s just waiting and watching for more data to come in to guide them.
So not to put words in your mouth, but maybe you’re more in the camp then that the higher rates that we’ve been seeing is a good sign for the economy versus a bad sign for the economy?
I think in the near term, it’s a good sign. It means that the data is coming in positively. The data is backwards looking, though. So I think inevitably the lags will kick in and higher rates will start hurting certain pockets of the market. You know, what’s happened is so many high quality companies locked in such low cost of debt and so many Americans locked in such low cost of mortgage rates. Right. Three, three and a half percent, you know, maybe a year or two years ago that it’s just taking long for the transmission mechanism of higher rates to come to the economy. We just have way more fixed debt than we used to. Europe is a place where the transmission mechanism is perhaps working faster because more of their lending to companies is floating rate at banks. So the places where we’re going to see the pain and we’re already seeing pain now are pockets that are more floating rate. So commercial real estate is a good example. A lot of floating rate debt there. You’re talking about people that borrowed at like, two percent, three years ago, and now they got to roll their debt at like seven percent. Right. It’s going to create issues. Bank loans. Bank loans float and the cost of debt is effectively double. The average spread on the bank loan index going back 10 years is about 500. And short term rates are now 500 basis points. So these companies went from borrowing at five percent to now having to pay 10 percent. It doesn’t happen overnight. It takes time. Those are those lags that everyone talks about. And I think that they’ll still come through eventually. And it’s probably going to happen sometime in the fourth quarter or first quarter next year. So right now, the move higher in rates, I think it’s in reaction to the positive economic data that we’re seeing. But I still think it’s an attractive entry point. If you haven’t owned long treasuries or assets that have interest rate risk, it’s been a good thing for you. So congratulations. But now it’s probably one of the cheapest parts of the market. I mean, you want to buy assets when people are pricing in all the bad things. There’s not much downside left. When I think about Treasuries, that’s kind of how it feels right now. Like everything bad that could happen is happening or has happened. Right. The Fed is hiking. Inflation was high. Foreign buying is very low. Economic data surprisingly upside. So it’s kind of like all the bad news seems to be in. Last week was interesting because you had the services PMI come in stronger than expected. It will jump up. I think it went from like 52 to 54 or something. If it’s north of 50, it’s expansionary. And the economy in the US is very service oriented. And off that news, the bond market didn’t really move much. It’s already kind of at these high levels. I think you would have expected another move higher in rates on that news, but it kind of just settled in. So the big headwind right now is the supply. There’s just a ton of Treasury supply coming. But if you get any data surprise to the downside come Q4 or maybe Q1 of 2024, I think that could ignite a pretty strong rally in rates. So the thing to worry about is really, does growth stay stronger than expected? We grow our way out of this, right? Yeah, absolutely.
So would you agree that the Fed is much more influential in determining short term rates and the market is much more influential in determining like 10 year yields?
Yeah, I agree with that. I think that’s accurate.
00:10:10 – 00:15:02
So maybe back it up and help our listeners understand what makes the 10 year yield move in either direction? What does it mean when it’s moving up or when it’s moving down?
Yeah, I mean, there’s different ways to model that have come out from different participants to like estimate what the fair value for the 10 year should be. One of them is what is the neutral rate of interest that’s neither accommodative or restrictive? The R star. And that’s, I think, the first layer. So let’s just throw a number out and say that’s like 2%, right? Then sometimes people say, well, then you need to layer in what long run inflation will be over that 10 year horizon. So let’s call that, that’s another 2% or so if core CPI gets back down to that level. And then some term premium, maybe that’s 50 basis points. So that would get you to like a 4.5% 10 year Treasury yield. You’re getting the neutral rate plus some premium for inflation over 10 years plus some term premium. And you could argue over the term premium, maybe it’s supposed to be 50, maybe it’s supposed to be a hundred. If you think it’s going to be a hundred, then you should think 10 years going to 5%. Now on the flip side, there’s buying from pensions and there’s buying from money managers and other institutions that kind of can drive the fair value below that four and a half number we just came up with, things like QE, right? That’s why we got to such low levels is that the buying outside of those that are just looking at that fair value coming in, maybe it’s lack of supply, maybe it’s foreign buying and so on and so forth. So part of it’s driven by kind of expectations of inflation through time. And then part of it’s just driven by the supply and demand of bonds that are out there. And that can be, things like QE can affect that, right?
So that first 2% that you called, I was picturing in my head is almost like the neutral rate. What determines that? What would cause that to be higher or lower? Or is that just fairly static across time in that assumption or that model?
That’s the big debate right now is, are we in a new world of higher inflation where the neutral rate would need to be higher? Whereas if you go back to like the last 20 years pre-COVID, let’s call it when we were in this like world of secular stagnation, where there was arguments that maybe that neutral rate is much lower since we’re living in a world of lower growth, lower inflation, so on and so forth. So depending on how things shake out and what the future looks like, maybe that neutral rate is higher. What are some things that could make inflation and growth stay higher? There’s like the three D’s I call it. It’s like demographics, right? We’ve had a smaller workforce every year going back the last 10 years because the baby boomers are retiring. We also stopped immigration pretty aggressively too. So demographics are part of it. You got defense spending, right? Governments are definitely spending more on defense and that could be inflationary, expansionary. We’ve got spending on decarbonization, right? There’s going to be trillions of dollars spent on decarbonization. There’s infrastructure spending that needs to happen in the US. There’s all these sources of potential growth that are coming that in theory could keep growth higher, inflation higher. And this is not a bad thing for the economy, but it just means that rates will probably have to be higher. And so I guess the real truth will be shown is after we kind of get through the next 12 to 24 months, soft landing, no landing, hard landing, whatever, what comes next? And are these long -term forces that are potentially pushing through into the economy going to keep growth and inflation higher in the future?
Got it. So pivoting to mortgage backed securities, what are you seeing in the mortgage backed securities market now?
Yeah, mortgages look the most interesting they have in almost 10 years. If you look at the spread on current coupon mortgage backed securities, which are the bonds that are being manufactured today by the loans being made today. So these are like seven and a half coupon loans get packaged into six and a half coupon bonds. The spread on them somewhere call it between like 165 to 175 and relative to corporate spreads, which are almost a hundred or a hundred ish, maybe a little bit wide of that. It’s the widest difference to corporates that it’s been in the last 10 years. It’s 99th percentile if you charted it on a graph. And why is it so cheap? Well, mortgage products, agency mortgages are kind of like vol products. So when vol is low, spreads are tight. When vol is high, spreads widen and interest rate volatility is really high.
00:15:03 – 00:20:07
So that’s one thing that’s caused mortgage spreads to widen. Why is interest rate volatility so high? Because the Fed’s been raising rates aggressively. And there’s a lot of uncertainty around where long -term rates should be based on all these things that we’ve been talking about. And then there’s a lot of supply. So the Silicon Valley bank and signature bank went under in March and the FDIC took over their assets and been liquidating them through time. We’re through about 80 % of the supply of the Silicon Valley bank assets. There’s about 20 % of the supply left, about 20 billion left. And our traders think that they’ll get done with it over the next 12 weeks or so. So that basically puts it after Thanksgiving. So we think that as rate volatility subsides and they get through the supply, when you come out after that supply and you look into supply next year, it’s down massively because home purchase activity is so low that there’s not going to be much supply and that’ll make spreads tighten. And by then we should have also more certainty around the end of the hiking cycle and rates and whatnot. So it’s been cheap like that since the beginning of the year, really kind of these 160 ish spreads. It got as tight as 120 before Silicon Valley bank, just to give you an idea of the upside. So if mortgages just tighten 20 basis points as a basket, they’re a pretty long spread duration asset. They’re about five years. And so 20 basis point spread tightening equates to a hundred basis points of excess return with rates unchanged. So if things just normalize back to kind of where they used to trade, you have a ton of upside and mortgages, you have no credit risk. And presumably if we do see a hard landing, that should be bad for corporate spreads and mortgage spreads are already so wide. I just don’t see them widening that much. So just like Treasuries, we talked about pricing and all the bad stuff, mortgages are the same story. It’s like pricing all the bad stuff right now.
So you’re saying the spread, when you’re talking spreads, you’re talking spreads compared to the 10 year Treasury yield?
Yeah, this is spreads compared to kind of a 50 -50 blend of the five year and 10 year. That’s what we quote.
And wider means you’re being paid more to take that risk in certain markets where the spreads are wider and narrower means you’re really not being compensated for the excess risk over the Treasuries. So they’re wider now. I guess I have a dumb question. You’re talking about their duration of five years with rates being so high. If mortgage rates come down, wouldn’t those bonds be prepaid maybe quicker than in another type of environment?
Absolutely. The high coupon loans will refinance faster. So the key is to not just own a bunch of those high coupon bonds. You buy lower coupon bonds, kind of like blend across the universe to create a portfolio that has a good, what we call convexity profile, which basically means you try to find assets that aren’t too callable. You don’t want to own just $103 price bonds that will get called away. You want to try to mix in some low discount bonds and create a portfolio that can do well in both rising and falling interest rates. And that’s kind of the environment you’re in right now, you can put together a pretty attractive portfolio that yields maybe not that 165 over treasuries because you’re buying the most premium bonds there. But you can build portfolio that’s kind of in the mid nineties, probably has a spread of like 110 to 120 over treasuries that has a good upside of rates fall. And you have no credit risk. And it’s just, for whatever reason, the market hasn’t aggressively chased this trade yet. It’s been kind of like a slow addition. Money managers are going overweight. There was an article on Bloomberg last week about a variety of different money managers and hedge funds playing this trade. So I just think it’s going to take time to realize the value that’s in those assets.
And why no credit risk, Ken?
Fannie, Freddie and Ginnie Mae who issued these bonds, they take the credit risk of those assets. When they package up these bonds, usually pay a small fee from the interest. Let’s say your loans have six and a half coupon. We take, let’s say 50 basis points every month. And that money goes to Fannie, Freddie and Ginnie Mae, almost like an insurance payment. And then Fannie, Freddie and Ginnie Mae then guarantee the credit worthiness of those securities. So you just take on prepayment risk. If a loan defaults they actually buy the loan out of the mortgage trust and they pay back full principal. So you’re never taking the principal risk. In fact, the defaults come through to you as a prepayment.
So those are agency -backed mortgage bonds in that instance. There are also non -agency -backed mortgages?
There are non-agency -backed mortgages. In that case, you still have the prepayment risk that never goes away. But then now you’re exposed to the credit risk of the borrowers, which in today’s environment we think is very low.
00:20:08 – 00:25:03
Loans being made today are very high quality. You have to put money down. You have to put at least 30% down for most non-agency loans that we see, unless you’re really high, like jumbo prime, then you’re going to your bank and maybe you can put 20% down. And we’ve seen very minimal losses because people have skin in the game. And when home prices are up so much, people have equity and they’re not going to walk away from that equity. That was really what drove defaults during the global financial crisis is a lot of people didn’t put any money down. And then as the home price went down, why pay this? I can go rent for cheaper. I can go buy the house next door for half price. This environment is much different. If you want to go rent, it’s probably about the same if not more. And if you’re already in that mortgage, you should do everything you can to keep that house because that 3%, 3.5% mortgage is extremely valuable.
Yeah, we’re definitely seeing that in terms of the lack of inventory. Ken, how are mortgage rates determined?
Yeah, it’s really determined by the price where the mortgage-backed securities trade. And so, one observation that many people have made is how come mortgage rates aren’t tighter or lower than they are, because usually they’re a certain spread over the 10-year Treasury. Well, that spread is driven by where the mortgage bonds are trading. So since mortgage spreads are really wide, that makes mortgage rates higher. And so in order for mortgage rates to come down, holding interest rates flat, let’s say the 10-year doesn’t move. If mortgage spreads came in and people started buying these MBS that look so cheap, that would then make the mortgage rate available to the consumer come down as well.
What’s the historic spread usually over the 10-year?
Something like we got to a 3% mortgage and rates were like 150. So I think something like 150, going back through time, sounds about right.
And now it’s three plus, right? The spread?
Mortgage rates are 750 and treasuries are, yeah, 425. So it’s like 325 right now.
And you explained this a little bit, but maybe one more time, since we’re talking about it within the context of mortgages, why are the spreads wider now?
Rate vol is high. The Fed’s not buying anymore. There’s all this supply coming from Silicon Valley Bank. So in anticipation of the supply, the buyers have backed their bids up, demanding a wider spread to buy these assets. And through time, we think as rate vol comes down, as the supply from the FDIC goes away, we’re going to enter an environment where spreads have a way to come in.
So this was the post-Thanksgiving when you were talking about working through that inventory. So not saying anything specific, but it’s possible mortgage rates may back down late this year.
And interest rates could fall too, right? You get some bad economic data, you get some idiosyncratic event, and you could see long rates come down and mortgage rates come down together. That probably happens by the way. When long rates come down, that means vols coming down and mortgage spreads will probably come down with them. And that’ll help people out there looking to buy homes, right? And that mortgage rate that’s quoted out there, if you go to a private bank, you could probably do a little bit better than the conventional rate that’s quoted, right?
Sure. Yeah, absolutely. How big was the Fed buying mortgage bonds in all of this?
They were huge. In fact, one of the things that makes active management so important when you’re investing in mortgage backed securities today is that the index is dominated by these low coupon bonds that the Fed basically owns two-thirds of. So if you think about what happened back in 2020, 2021, cut rates on the front end of zero, the ten-year got all the way down to 50 basis points in the summer of 2020. And everyone was either buying a house or refinancing at like a three, three and a half percent rate, right? At the same time, the reason that spreads were so tight on MBS was the Fed was buying. So the Fed was buying about 40 to 50 % of the float of those assets. And so that not only does the mortgage index get comprised of a lot of these low coupon bonds, but the Fed also happens to own a lot of the float. So if I’m an indexer or I manage an index fund, for example, I have to go buy Fannie 2s and two and a halves, and guess what, the Fed owns a lot of it and there’s not a lot of it available to buy. So it actually trades tighter. So if you just bought the MBS index, you’re going to be forcing yourself to buy some of these low coupon bonds that have these tighter spreads.
00:25:03 – 00:30:03
Whereas if you’re more actively managed, you can kind of try to underweight those low coupons. You want to have some of them and try to buy more kind of in the belly of the coupon stack, or maybe some of these higher priced new origination bonds that have that really, widespread we talked about. So that’s why active management we think is important. You can also mix in some non-agencies and sometimes pick up 100 basis points over agencies. What really looks kind of interesting to us right now is Fannie and Freddie, they also package up their credit risk and sell it. It’s called credit risk transfer. They’re a credit link note, but your credit risk is the losses on these reference pools of Fannie, Freddie origination, which Fannie and Freddie origination is really high quality. There’s a lot of high standards to make those loans. And you can buy different pockets of credit risk. You can buy below investment grade risk, and you can buy more investment grade risk. And some of the triple B type risk in that space is trades today, probably like 250 to 275 over SOFR. And SOFR is at 5%. So you’re talking about almost an 8 % yield for investment grade Fannie, Freddie quality underwriting. And part of it’s playing just credit spreads are wide, part of it’s playing the fact that the curve is so inverted that mortgages are longer, they sit out the curve and the cheapest part of the curve is like the short -term rates. Everyone’s favorite trade this year, six -month T -bills.
So I was going to ask you about that, just the active management with bonds. And you touched on it a little bit, just dive in deeper. It seems the case for active management is much more prevalent when it comes to investing in the stock market. People talk about that, I think a lot more than they talk about how necessary or how much of a good idea it is to index in fixed income. And part of that, I guess, is what you were talking about is the makeup of the bond index is basically just the debt that’s out there. And if the debt that’s out there doesn’t mirror what you would like in a portfolio, there are opportunities outside of kind of forcing yourself to mirror that index?
Yeah. And right now is actually the most interesting time to actively manage fixed income because there’s such a wide variety of assets that have been mispriced. The worst time was during QE because what QE did is basically not only compressed the risk -free curve, it also compressed spreads. So there wasn’t much differentiation from one asset class to the next. Everything was trading kind of like right on top of each other. I know this is just like an audio podcast. If we have a way to show people like a graph, we can send it to you. It’s pretty interesting. It basically plots each asset versus its own spread history going back 10 years. Mortgages are 99th percentile. So when we say 99th percentile, it means that the spread has only been wider 1% of the trading days over the last 10 years. So the higher the percentile, the cheaper you are. Corporate bonds, IG and high yield are like sub 40th percentile right now. You’ve got CMBS that’s like 98th percentile because of all the fears about commercial real estate. And then there’s other assets that are kind of sitting like mid 70s to the mid 80s. If I showed you that same chart during peak QE, everything would have been towards the bottom of it. So everything would have been, spreads would have been tight. Now there’s all this variability. So in theory, corporates have rallied, this other stuff has not. So the corporates buy mortgages, over time the relationship should normalize and then mortgages will create excess return either because corporate spreads widen or because mortgage spreads come in. But when you were in the world of QE, there was none of this opportunity available. So what you actually saw, if you looked at the performance of accurately managed funds versus the index, the excess return collapsed. One would look at that and say, why should I buy actively managed bond funds because they’re not really giving me any excess return? Well, that was the worst environment for them. If you go back to the first half of the decade of the 2010s coming out of the global financial crisis, you had a ton of volatility, rates were high, you had a bunch of stuff going on with the European debt crisis. And that created all this dispersion between one asset class trading tight, one asset class trading wide, and you could rotate across these different assets to create excess return through time. We’re back to that environment now with rates higher, rate vol higher, and there’s dispersion with beliefs on credit worthiness of commercial real estate versus bank loans, for example. And so I think that leads to a more challenging environment, but it means that if you make the right bets, then you can create much higher returns relative to the index. So from an active management standpoint, it’s a great environment. We don’t want to go back to those days of QE.
00:30:03 – 00:35:01
Those are good for backwards looking returns, but they’re not good for forward looking returns. But it’s been a challenging market. I think the most challenging thing for our business really has been the T-bills being so attractive. I think we hit record money in money markets. At some point in time, I can’t predict when short term rates will drop right the Fed will cut either because we’re going into a recession or maybe inflation’s coming down and we’ll go back to their neutral rate, at which point that money is going to go somewhere. Some of it will go into stocks, but a lot of it will pile back into bonds. And that’s the big catalyst for the spread tightening across high quality fixed income that I see. I don’t know when that’s going to happen. It’s probably not this year. It’s probably sometimes towards the middle or end of next year when you’ll see that potentially coming into play. And that’s when everyone will be like, oh, I should have bought some bonds and locked up in some rates. And the money will all chase rates back lower.
That’s conversations we’re trying to have right now with a select group of people who do have, I would say, an elevated position in short term fixed income or money market for good reasons, in terms of it is short term conservative money. But we are trying to get them to lock in some intermediate term yields for the exact same reason you mentioned. Did you have any idea when you started a career in mortgage backeds that you would get the Great Financial Crisis, QE, the sharpest rate increases in a summer that we’ve seen in a long time? Maybe it’s not what you signed up for 20 plus years ago.
Yeah. Well, it’s funny. I was teaching a class at USC, which is the University of Southern California. That’s down the street from our office. And I was telling these students, they’re mostly juniors and seniors about to go into the workforce. I’m like, this is not a normal bond market. This type of rate volatility, the two year moves 20 basis points a day. This is not normal, but it’s a good learning experience. And frankly, for investors, I think it’s a great thing that you get yields back up to these levels. You were just forced to go into such risky investments. And now, you can sit in T -bills earning five and a half. You can buy high quality fixed yielding income probably like six, six and a half right now, investment grade. You go back and rewind the clock two years, you have to lever up high yield to get four. I mean, high yield got to about a 3.6 yield. So to get a four yield, you have to lever up high yield. Whereas now, you can just get four risk free in Treasuries. So I think it’s a good thing for investors in the long run. It’s just been painful for participants market that have been in the market during it. But this is good for the future, I think. And it makes the case for fixed income over equities when you’re seeing yields that can compete with the long run return on the global ACWI, which is like six and a half percent roughly.
Yeah, absolutely. We’ve talked about Treasuries a little bit today so far. Do you have any long term concerns with Treasuries? We saw the Fitch downgrade, which kind of echoed the S&P one from 12 years ago, or is that more of a long term outlook, not a day to day investment topic?
It’s a philosophical topic as well. But I mean, look, the deficit spending in the country is getting out of control when you look at it as a percentage of GDP and all these different metrics. And they’re going to need to issue more Treasuries in the future. So I think in the near term, I do believe that from a tactical standpoint, you’re going to make money in long rates, there’s going to be some kind of growth slowdown end of this year, beginning of next year, while you’re making money in long Treasuries. But then, what is the reaction by the government to the slowdown, if we go into a recession? We’ve seen that QE doesn’t work. And everyone’s so comfortable now with fiscal stimulus that do they go back to more fiscal? And then that would mean higher deficits, more Treasury issuance. So I think in the kind of like short to intermediate run, I’m not concerned about it. I think tactically, we’re going to make money in Treasuries. But then, depending on what the reaction is, you may want to be getting out of them in the future and sticking to short term Treasuries. So I think it’s hard to predict, but the deficits, if you really dig into it, it’s pretty terrifying. And Treasury issuance has to go up to fund it. And you would think that would be negative for rates in the long run.
We saw some calls, and we can end on this, for people when the rates were near zero or at zero, people were talking about maybe issuing 30, 50, 100 year Treasury notes. Is that just impractical and just crazy theory or did they miss an opportunity to do something like that?
They should have done it. There’s a lot of countries that did. I mean, Austria issued 100 year bonds. So we missed it, I guess.
00:35:02 – 00:40:02
All right. Last question for me, Ken, and I really appreciate your generosity today. It’s been a fantastic conversation for our listeners. One of the basics we get about bond investing is why investing in co mingled vehicles, a mutual fund, an ETF, is more efficient for individual investors than buying and owning individual bonds. And if you don’t mind just walking our listeners through that as a takeaway.
Well, I think when you buy individual bonds on the retail side, there’s usually a wider bid ask probably. So you’re probably paying more than you would if you got an institutional fund. Like we’re going to get kind of the cheapest access to those securities, I would say. That’s one thing. And I know because I’ve looked at buying individual bonds myself. And the other thing is diversity, right? Just think about you want to go out and you buy like 20 corporate names and you want to get access to the corporate credit market. You could have two, three names that go bust and then all of a sudden you’ve got a lot of vol in your portfolio and not good liquidity. If you do it in a fund format or an ETF, we’re going to own hundreds of different bonds in those portfolios. And if you need to get out, you’re not going to get so much on that bid ask from that one position where you’re going to get out of basically NAV. So I think for individual investors, bond funds, ETFs, I think they make a lot of sense. You get way better liquidity than you would if you went into single name bonds. Stock market’s totally different. Stocks have much better liquidity when you’re in kind of smaller ticket sizes.
Awesome. Great. Ken, thank you so much for your insight today. It was a great conversation and I think our listeners will find it very valuable. Appreciate it.
Thanks, Sammy.
So Bob, just wrapping up this conversation with Ken, someone you had suggested we have on the podcast. I thought it was a tremendously productive conversation. He had a lot of interesting insights that I don’t think I’ve heard recently. What were your impressions of Ken’s overview?
Yeah, I thought it was a great discussion. Ken is one of the top people in the country as far as being an expert in mortgages. So he definitely provided some good insight. He got a little technical, so I’ll try and just connect the dots for our listeners in case it went over their head. Specifically, his comments on how mortgages are priced. He mentioned interest rate vol a couple of times. So what he means by that is interest rate volatility and why interest rate volatility matters. And he used I think the phrase prepayment risk and it’s exactly that, prepayment risk. So if you think of yourself as a homeowner, when you take out a mortgage, you can refinance at any time. And that is what is the risk. That’s the risk that mortgage investors are taking. So if you think about it, if you take a mortgage and rates are at 7% today, if rates go up to 9% or 10%, you win. You locked in at a low rate and market rates are now at 9% or 10% and you have an attractive rate. If rates drop quite a bit from 7% to 3 or 4, you win, you refinance. You got a 3 or 4% rate now. So for the investor who is holding the mortgage bonds, that’s the risk they’re taking. They’re taking the risk that mortgage rates will move a lot. If rates just stay at 7%, then they’re just collecting a healthy coupon. So you see higher spreads relative to Treasuries when the market is expecting more volatility in interest rates. And that’s what’s happening right now. Where if you were to think about it, if you were to take a new mortgage right now and you had to actually pay for the ability to refinance in the future, you would pay a little more than average. You would pay more than you would have paid two or three years ago. Because I heard a client say, a realtor told them, marry the house, but date the mortgage. Because the idea is take a 30-year mortgage, but you have no intention on paying that for 30 years. You’re going to refinance out of it. So that’s what is meant by interest rate volatility. So then just to kind of walk through his math, he said on average, you see mortgages priced at about one and a half percent above Treasuries. And right now they’re about 3% above Treasuries. So there’s an extra one and a half percent compared to where they were just a couple of years ago. And that’s for two reasons. One, the higher interest rate volatility that we just talked about. And the second that I thought was really unique insight that Ken shared with us is supply from the Silicon Valley Bank liquidation. So when Silicon Valley Bank went under, the FDIC seized the assets, which were a ton of mortgages, and they’re selling them and they’re saturating the market. So this is what people call market technicals, where the FDIC is not a for -profit enterprise. They’re just selling these things to the market. And in doing so, they’re providing so much supply.
00:40:02 – 00:42:43
When you think about supply demand, they’re pushing the price down, which means pushing the yields up. And his team thinks that the trade has about 12 weeks left before they kind of finish flooding the market. So that’s also part of it. And I looked at the data to try and quantify that and that’s why 25 to 50 bps is an estimate since that’s how much the spread has increased this year from pre-Silicon Valley Bank to post in March there’s an extra 25 to 50 basis points in that spread. So I thought that was some unique insight. So just in general, I hope our listeners now have a much better understanding of the mortgage market and find that interesting. And it also just speaks to one of the many ways to invest. And we own Double Line Total Return for a lot of our clients, and it takes unique risks that now you understand what risk you’re taking and how you get a return for taking that risk.
Great. Yeah, absolutely. I thought it was a fascinating conversation as did you, and I did learn a lot about mortgages and fixed income.
Anything else, Bob?
No, I think that’s it. It’s a pretty technical podcast, but hopefully people find it interesting.
All right. Thank you, Bob, for jumping in at the end and helping clarify some points. Have a great week.
You too. Thank you.
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