The Federal Reserve Bank has plans to gradually raise interest rates this year, which has many investors rethinking duration strategies for their fixed income portfolios. Duration measures the length of time you are required to wait to collect interest payments and return of principal on a fixed income investment. This concept differs from maturity, which is simply how many years the investment is expected to last. Duration is an important concept because it can be used to predict how changes in interest rate may impact the value of fixed income investments. In other words, duration indicates the level of interest rate risk associated with a particular investment.
Key to the relationship between interest rates and fixed income assets is the understanding that interest rates and asset prices move in opposite directions. When interest rates rise, all other things being equal, the value of a fixed income investment declines and vice versa. If you own an asset that pays a fixed yield of 3% and interest rates rise, the fixed yield provided by this product becomes less attractive and the asset may lose value. The higher the duration of an asset, the more its price would be expected to fall as interest rates rise.
Duration is measured in years. As a general rule of thumb, every 1% shift in interest rates causes the value of a fixed income investment to move by roughly 1% in the opposite direction for every year of duration. For example, if an asset has 5-year duration and interest rates increase by 1%, the value of the asset would be expected to decline by approximately 5%. Conversely, if an asset has a 5-year duration and interest rates drop by 1%, its price would likely increase by 5%.
Duration has its biggest impact if a fixed-income investment is sold before it reaches maturity.
This is because if you buy a 5-year bond at par that yields 3% and hold that bond to maturity, you will receive $30 each year and your $1,000 principal after five years, regardless of interest rates changes. However, if you sell the bond before its 5-year maturity date, its’ value will be more or less than $1,000, depending on the fall or rise of interest rates. The chart below indicates changes in duration at different maturities and yields:
As shown in the chart, as yields move higher, duration shortens. For example, at face value, the duration of a 5-year bond yielding 4% is 4.49 years. Duration condenses as yields increase because more of the overall value of the investment is being received prior to maturity. At higher yields, monthly coupons comprise a bigger share of the cash flows collected from the investment.
When investors talk about short duration, they generally mean a fixed income asset that matures within three years. Intermediate duration typically refers to an asset that matures in three to ten years. Long duration investments usually take ten or more years to mature. While long-duration investments usually offer the highest interest rates, they are considered more risky since sharp price declines may occur as interest rates rise.
In environments where rates are expected to increase, most investors prefer to hold short duration investments. However, duration is only one of several factors that impact the price of a fixed income investment. Other mitigating factors include the liquidity of the investment, its credit risk and whether the asset is convertible and/or callable.
Mortgage pool funds are ideal instruments for short duration strategies due to the unusual characteristics of these investments.
The portfolios of these funds consist of property renovation and/or development loans that are primarily short-term in nature. The maturities on these loans typically range from one to five years. Because of short duration loans, mortgage pool fund portfolios are relatively impervious to changes in interest rates.
Most short duration investments offer relatively low yields, but mortgage pool funds are at the higher end of the yield spectrum. At present, when 2-year and 5-year AA rated corporate bonds are yielding just 1-2%, most mortgage pool funds are yielding upwards of 7-8%. Higher yields make the durations for mortgage pool funds even shorter and further reduce their sensitivity to interest rate risk.
Mortgage pool funds are able to offer higher yields than other short duration assets due to their specialization in a lending niche with few competitors. Fix-and-flip loans are bread-and-butter investments for mortgage pool funds but poorly understood by most banks. Banks lack the deep knowledge of local real estate markets, customized due diligence tools and boots on the ground to underwrite fix-and-flip loans. Because few lenders serve this market, fix-and-flip borrowers must be willing to pay higher rates to secure financing for their projects.
While there are risks involved in fix-and-flip projects, mortgage pool funds have developed effective strategies for managing these risks.
The first is diversification; loans in the portfolio are diversified by property type, maturity date and geographic location. The typical mortgage pool fund has more than 100 different loans in its portfolio. In addition, these loans are secured by a tangible asset (real estate) and borrowers are usually required to invest some of their own capital in the project. Another tool for managing risk is the loan-to-value ratio, which measures the loan amount as a percentage of the property’s sale value. More conservative mortgage pool funds such as the Socotra Fund target average loan-to-value ratios below 70%. By restricting loans to 70% of property value, a safety cushion is created that enables the mortgage pool fund to recover the full amount of principal and interest if a loan defaults and the property must be sold to cover the debt.
With interest rates forecast higher for 2017, investors should assess the duration of their fixed-income portfolio. Mortgage pool fund provide an ideal tool for locking in above-market yields and minimizing exposure to interest rate risk.[/fusion_text]