Investment Management: Good News and Bad News About Interest Rates
Interest rates play a key recurring role in investment management activities and results. For example, here is how Martin Zweig described the importance of interest rates: “Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate — primarily the trend in interest rates and Federal Reserve policy — is the dominant factor in determining the stock market’s major direction.”
This article will provide a summary of how interest rate fluctuations can impact investment managers. The overview includes four specialized strategies that demonstrate how New Residential Investment Corp., a public real estate investment trust (REIT) traded on the New York Stock Exchange (NYSE ticker symbol: NRZ), overcomes interest rate changes and challenges.
Interest Rate Changes: Inverse Relationships for Fixed-Rate Debt Securities
Interest rates and fixed-rate securities such as bonds exhibit what is called an inverse relationship — when one goes up, the other goes down. For example, if an investor buys a 20-year corporate bond with a fixed-coupon rate of six percent at a selling price equal to the par value of $1,000, the bond will subsequently increase in value as long-term interest rates decrease (and vice versa).
The price changes are due to the “scarcity value” (or lack of it) of a particular bond. With the example of the six-percent coupon for the bond, investors would not be able to buy the same bond for $1,000 if interest rates decline since it is now worth more than $1,000 — because a newly issued bond would be sold at a lower interest rate like 5.75 percent. Conversely, if Federal Reserve policy and economic conditions cause interest rates to increase after an investor buys the six-percent bond, new issues of similar bonds will be at a higher rate (perhaps 6.25 percent). If this happens, the six percent fixed-rate example would decrease in value because it is paying a lower rate of interest than the prevailing market of 6.25 percent or higher.
Other factors such as credit risks and the “yield curve” also play a role in price changes for fixed-rate vehicles. If a bond’s credit rating is reduced (or raised), the market value is likely to decrease (or increase with a rating improvement). The yield curve expresses the changing relationship between short-term and long-term rates. Although long-term rates are frequently higher than short-term rates, when longer-term rates are lower this is referred to as an inverted yield curve. Until this occurred briefly in late 2018, the most recent previous examples were during several periods of 2005-2007. Adding to this complexity, interest rate fluctuations are caused by multiple factors that include tax considerations, prevailing rates of inflation, risk tolerance by investors and rates of return on competing investments.
Profiting from Changing Interest Rates — Portfolio managers such as those at New Residential must regularly balance the often-competing elements that can cause interest rates to change. Fluctuating interest rates might be viewed as a certainty, but the uncertainty about precise timing can provide periodic investment opportunities (as noted in the following section).
Investment Management Strategies for Overcoming Interest Rate Challenges
New Residential focuses on opportunistic investments that include mortgage servicing assets and residential mortgage-backed securities (RMBS). Here are four of the investment strategies used by NRZ to handle constantly changing scenarios influenced by financial volatility such as interest rate fluctuations:
- Asset Specialization — New Residential emphasizes specialized assets such as non-Agency RMBS and excess mortgage servicing rights (MSRs). In contrast to many fixed-rate debt instruments that typically decrease in value as interest rates increase (as noted above), excess MSRs should appreciate in value when rates increase.
- Active Management — Unlike a passive management approach illustrated by assets such as index funds, an active asset management strategy is well-positioned to make portfolio adjustments when circumstances change. This allows New Residential portfolio managers to monitor, analyze, sell, buy and refinance assets on a daily basis when required.
- Undervalued Assets — NRZ’s opportunistic investment style features an ongoing emphasis on finding undervalued assets. One common scenario occurs when institutional investors such as banks are forced to sell securities such as RMBS in order to increase capital reserves. Another example is illustrated when New Residential acquires under-performing mortgage portfolios and transforms them to re-performing status by emphasizing loan workout strategies instead of foreclosures.
- New Acquisitions — New Residential has recently acquired companies that facilitate more internal control over mortgage servicing and loan origination decisions. This reduces the inherent uncertainty about future mortgage pipelines. Recent NRZ acquisitions also reflect the changing structure of the mortgage servicing industry.
About New Residential Investment Corp. — Board Chairman/CEO: Mike Nierenberg
New Residential is qualified in all states for ownership of mortgage servicing rights. The company is also approved as a servicer for Fannie Mae and Freddie Mac. NRZ added in-house mortgage origination and mortgage servicing capabilities to their operations during 2018.
Mike Nierenberg has served as New Residential’s Chief Executive Officer and President since 2013 and Board Chairman since 2016. He was a pioneer in creating an investment market for excess MSRs.