Where to look as U.S. rates rise

By Sarah Cunningham-Scharf | November 24, 2016 | Last updated on November 24, 2016
3 min read

Now isn’t the time to buy securities like 30-year U.S. Treasuries, which were yielding a little over 2.5% at the end of October, says Ignacio Sosa, director of the product solutions group at DoubleLine Capital in Los Angeles. (As of November 21, 30-year U.S. Treasuries were yielding around 3%.)

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“The level of yield that the investor is getting per duration is almost at the lowest of all time,” he explains. “So you’re getting paid less to take on more risk. [Buying those securities] only makes sense if you believe interest rates are going to stay this way, or fall forever.”

And that’s unlikely, says Sosa, whose firm manages the Renaissance Flexible Yield Fund. “Interest rates in the U.S. have seen their lows,” he predicts. “The 10-year U.S. Treasury is likely to see a 2% rate towards the end of this year. It will then go up steadily, gradually.” This is all the more likely now that the U.S. Federal Reserve has strongly hinted a rate hike is coming in December.

Read: Yellen says case for rate hike has strengthened

So, he says, “To be buying securities like [those] doesn’t sound attractive to us. If you want to stick with government risk, you’re much better off buying TIPS, or Treasury Inflation-Protected Securities. That’s a better way of recognizing that [interest] rates could go up [and] inflation could go up, and to not take the risk of going much further out on the duration scale at very low yields.”

Other opportunities in the securitized space

Many U.S. banks are “withdrawing or retreating” from the securitized asset space, due mainly to tighter regulations, says Sosa.

“I’m thinking of the commercial mortgage-backed securities market, for example, as there are [are many] commercial real-estate loans that are coming due, or [that] have come due this year, and the banks are unable to renew these loans. Or, in the case of a new lender, to make a new loan because of Dodd-Frank and other regulations,” says Sosa.

This provides an opportunity because “these are very attractive securities,” he adds. “Generally you’re lending about 70% of the value of a building. So you have quite a bit of room for the building to come down in price; if it were to go down in price, you’d still be protected.”

Read: Benefits of flexible yield strategies

Also, consider that commercial real estate prices dropped significantly after the 2008 market crash, and have only recovered to near their old levels in major cities like New York, Los Angeles and San Francisco so far. “The United States has commercial real estate in many other cities that are still way below their highs. So, we think that this is a very attractive asset class,” says Sosa.

In addition to commercial mortgage-backed securities being undervalued, Sosa adds, “they’ve proven to be more resilient than corporate bonds. We think [they] offer a much better risk-return profile than corporate bonds.”

Residential mortgage-backed securities also look promising, says Sosa. If you look at “mortgage loans that were extended prior to the crisis, they have survived the worst already. The only things that would [significantly] impact them going forward would be a dramatic recession, much higher unemployment [and] a much greater fall in housing prices.”

And he’s not forecasting a recession in the near term. He adds, “For housing prices to fall substantially from here—[given] they haven’t yet recovered to 2007 levels in a lot of markets—you would need quite a bit of [a] shock to the system.”

Read: Don’t fear mortgage-related assets

In particular, residential mortgage-backed securities are attractive because they’re less sensitive to interest rates, says Sosa. Further, “even when credit products like corporate bonds fell out of favour last year, up until February, residential mortgages [remained] pretty stable.”

Read:

The best time to buy REITs

Don’t wait to learn about real estate investing

Determining property value for the PRE

Sarah Cunningham-Scharf