CHG Issue #166: Fixed Income Volatility

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In CHG Issue #163: Reframing the Bond Market we described how investors should take a fresh look at the bond market especially since it appears that the secular trend for interest rates is changing. We argued that the strategies that had yielded success in the past may not work in the future. Duration risk has been a tailwind for bond investors and is likely to become a headwind if the newly unfolding trend for interest rates is higher. Duration risk is more than a bet on the direction of interest rates, it includes where on the yield curve to invest and what sort of coupons to invest in: fixed or floating.

But the Fed just lowered interest rates, and we are saying that the trend is higher for interest rates, how does this synch up? Well, since the Fed lowered rates by 50bps on September 18th, we have seen five-year yields increase by roughly 10bps. Any point on the yield curve inside of the two-year has fallen while all other maturities have seen their yields rise since the Fed decision. This is another way of saying the yield curve has steepened which demonstrates just one dimension of the complexity in fixed income investing.

In CHG Issue #164: Real Estate in a Rising Rate Environment we followed up that analysis by making the case for structured products as a vehicle to get exposure to real estate in a rising rate environment. If yields are trending higher "bonds" would seem like a good thing to avoid (bond prices go down when yields rise), but since we can invest at different points on the yield curve and in fixed or floating rate securities just avoiding all fixed income may not be the best strategy, especially if rising rates also puts pressure on equities. If real estate benefits from rising rates and we can buy floating rate securities tied to real estate, then that seems like it might present a good opportunity to benefit from rising rates and improving real estate fundamentals.

In this unfolding analysis we have so far focused on just two linear risk factors: duration and yield curve risk; but this week we are going to explore a non-linear risk: volatility risk or convexity risk in the bond market. There is a vibrant equity volatility marketplace which is well known, but the fixed income volatility marketplace is less well known due to its complexity and opaqueness.

We have seen massive growth in the equity options markets since I first started out in equity derivatives at SIG back in 1996, and today there are many ETFs and indices that track various options strategies that were once only the purview of professionals. It is curious that while covered call strategies proliferate in the equity market and are widely practiced as a method to manage risk and generate income (both coherent but inaccurate descriptions of a covered call strategy) the same is not true in the bond market.

A mortgage-backed security (MBS) can be thought of as a traditional fixed-rate bond plus a short call option on that same bond; in effect an MBS is essentially a covered call strategy in the bond market. In a trend of rising interest rates, and falling bond prices, a covered call strategy can be a very attractive strategy, however today we find MBS trading at some of the cheapest valuations we have seen relative to corporate bonds for some time.

Corporate bonds are more closely linked to equity volatility since corporate bonds can be thought of as a short put on the enterprise value of a company. Publicly traded companies are typically lightly leveraged, as of Q2 2024 S&P 500 companies have an average 55% Debt/EV, and therefore equity volatility is based on the 45% of the capital structure which is roughly 2x leveraged and corporate spreads are based on the underlying volatility of the enterprise value of these companies. With a soft-landing becoming increasingly the consensus view it is no wonder why corporate spreads are low and the VIX is trading with a 17-handle.

Fixed income volatility is generally lower than equity volatility because debt is senior in the capital structure and therefore not as leveraged as an equity investment. This probably explains why option selling strategies in the equity market are more popular than in the bond market. However, given the leveraged nature of equities and the hyper-efficiency of that market the question investors should be asking is whether they are actually earning any income by selling these options or are they just picking up pennies in front of a steamroller. Just because the insurance on the stock market is more expensive, doesn't mean it is a good idea to sell it; think of selling hurricane insurance on a beachfront property in Florida, the premium is high but the likelihood of having to pay out on that policy is also high.

While the implied volatility of MBS is generally lower than equity implied volatility the option that MBS investors are selling is less efficiently priced than equity options partly because it depends on the behavior of consumers. MBS investors utilize prepayment models to estimate when homeowners will prepay their mortgages and the more uncertain interest rate changes are (aka higher volatility) the higher MBS investors value that prepayment option. Since the uncertainty around interest rates is higher today, even though the certainty around a soft-landing is high, the prices of MBS have suffered because the option value is perceived to be higher which commands higher spreads and yields for MBS.

While the market is uncertain around the direction of interest rates and the shape of the yield curve which have conspired to push MBS yields higher, the actual value of the prepayment option is far more stable than market expectations. In general, aggregate consumer behavior is not as efficient as the models predict because people tend to be irrational and do unexpected things. This is another way of saying that implied fixed income volatility does not always translate directly into more or less refinancing activity. This inherent inefficiency has created a fairly stable risk premium that can be harvested by sophisticated investors.

AGNC Investment Corp. (Nasdaq: AGNC) is one such investor and since their IPO in May 2008 they have consistently harvested this risk premium. Looking at their stock price, which is not as attractive as their underlying business because of poor liquidity and a quirky investor base, the magnitude of this risk premium can be seen by looking at the cumulative returns relative to the S&P 500.

Because of the complex nature of harvesting this risk premium and GAAP accounting it is difficult to present a better picture of AGNC's ability to consistently harvest this risk premium so this picture of cumulative returns will have to suffice. To put it simply, AGNC buys MBS and hedges the duration and yield curve risk by selling treasuries or fixed income derivatives to isolate the embedded option value of the MBS. By doing so they are effectively selling the prepayment option to homeowners and the long-term compounding of that risk premium can be seen in the stock price, despite the periodic volatility shocks which come from dividend investors who panic out during liquidity crises.

The AGNC stock price is a dirty representation of the MBS risk premium that is available to investors.? While equity investors increasingly slice and dice the stocks into different factors and risk premia and leverage those small edges many times to achieve hedge-fund like returns, this crude risk factor remains broadly available to investors of all shapes and sizes and has outperformed the S&P 500 since the lows of 2008 without the high leverage. Multi-strategy structured products funds have grown in popularity and there are more and more mutual funds that pursue similar strategies which give investors vehicles that are not as prone to the volatility of the public markets that mREITs like AGNC suffer under. As we showed in CHG Issue #148: Unpacking Investment Vehicles, it is important to discern the underlying business from the vehicle it is held in as the vehicles can impose qualities on the investment that are not related to the business. This can be used to your advantage, and it can be a disadvantage if you just passively accept the inefficiencies of different investment vehicles.

The popularity of fixed income volatility strategies is likely to increase as interest rates trend higher and investors look beyond duration risk for ways to profit in the next cycle. The universe of sophisticated investment strategies and associated technology has increased since the last bond bear market and there are more investment vehicles that provide investors access to these strategies which means investors will have more and better options for investing in the bond market which will also require greater discernment on the part of investors to differentiate between different investment vehicles and strategies.

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