RISR - RISR: Compelling 6.8% Yield From AAA Assets With Negative Duration

2023-05-09 07:35:07 ET

Summary

• FolioBeyond Rising Rates ETF is a fixed income exchange traded fund.
• The vehicle is a fairly new addition to the ETF universe, having launched only in 2021 and having only $56 million in assets under management.
• RISR is a fund that achieves the rare feat of having a negative duration of -7.9 years while paying a very attractive yield of 6.8%.
• The fund gives retail investors access to a niche asset class, namely MBS IOs.
• The vehicle is a great portfolio duration hedge, and had a stellar 2022.

Thesis

FolioBeyond Rising Rates ETF ( RISR ) is a fairly new fixed income exchange traded fund, having launched in 2021. The vehicle achieves the rare feat of having a negative duration and only AAA assets in its composition:

It is highly unusual to have funds with negative duration (i.e. the assets go up in value as rates rise), but more so when this pay-off profile is achieved without the usage of embedded derivatives such as swaps. RISR holds a large quantity of interest only (IOs) mortgage strips which give it its negative duration. The article explains in the ' What are MBS IO Strips ' section below the mechanics of MBS IOs and why they have a negative duration profile.

RISR has managed to achieve an eye watering 6% total return on a 1-year lookback, when fixed income has been decimated. If we look at its 2022 performance solely, the numbers are astounding, with the fund up more than 30% on a total return basis. The vehicle represents a very nice duration hedge, either for fixed income or equity portfolios. A retail investor who does not want to sell certain names (for tax reasons or other reasons), can now utilize RISR to hedge some of the duration exposure. Conversely, investors who believe rates are going up but do not want to speculate via inverse ETFs such as ( TYO ) can take that view via a positive carry fund like RISR.

The vehicle only contains AAA MBS bonds currently, but can have Treasuries in its portfolio as well. We expect the portfolio manager to switch a bit as interest rate views crystalize. The fund passes to investors the income it makes, and its current 30-day SEC yield is 6.8% (we have taken the latest 0.18 distribution here, multiplied it by 12 and divided it by its current price of $32/share to get this figure).

RISR is a great fund that gives retail investors access to a niche asset class, namely MBS IOs. The fund has a negative duration profile and has done tremendously well in 2022. Expect a less volatile 2023 where an investor can clip a very high coupon of 6.8% from AAA assets before it will be time to sell the name at the end of the year. We are on Hold for this name as of now, liking its duration hedge and dividend yield.

What are MBS IO Strips?

The practice of MBS 'stripping' consists of separating the principal and interest streams in separate securities with their own CUSIPs:

Mortgage backed securities can be stripped into principal only (PO) strips and interest only (IO) strips. The principal component of the MBS payment is used to pay down the PO strip MBS, while the interest component of the payment is used to pay the IO strip MBS. The bonds of stripped MBS therefore do not have a pro-rata principal and interest payment distribution to investors.

By separating the two cash-flow streams, investment banks manage to achieve separate securities with very different duration and pricing profiles:

IO strip investors receive only the interest component of the mortgages in the security pool.

• Assuming that a mortgage is held to maturity, the IO payments would be very high in the early years and very low in the later years.
• As interest rates increase, prepayments decrease, so mortgages last longer and the total dollars paid to IO holders rises; therefore IO prices can rise when interest rates rise.

A very nice graphic representation of the relationship of each 'strip' to prevailing interest rates can be found below:

Source: ExpertsMinds

Principal Only strips have very high positive duration profiles, while IO strips have negative duration up to a certain yield threshold.

To translate the financial-heavy language above, let us go through a real time example. If a homeowner took out a 30-year mortgage at 3.5%, they will be hard pressed to refinance when mortgage rates are at 6.5%. So there will be less pre-payments on mortgages (i.e. people staying in their homes), meaning the MBS bonds that contain these mortgages will be outstanding for a longer period of time:

The higher the duration of the MBS bonds, the higher the aggregate cash flows for the IO strip, hence the security goes up in price as rates increase.

A retail investor though needs to note that IO strip pricing is highly volatile when compared to other AAA assets, and also more illiquid:

The value of interest-only mortgage-backed securities (“MBS IOs”) is more volatile than other types of mortgage-related securities . They are very sensitive not only to declining interest rates, but also to the rate of prepayments . MBS IOs involve the risk that borrowers may default on their mortgage obligations or the guarantees underlying the mortgage-backed securities will default or otherwise fail and that, during periods of falling interest rates, mortgage-backed securities will be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate . In addition, because there may be a drop in trading volume, or an inability to find a ready buyer, MBS IOs may be illiquid . In response to changes in interest rates or other market conditions, the value of an inverse IO may decrease at a multiple of the decrease in the value of the underlying securities

We can see the illiquid nature of some of the IO securities in the RISR portfolio by looking at the valuation allocation for the holdings:

Most of the securities in RISR are Level 2 assets. The most illiquid type of bonds out there are Level 3 assets, which can have bid/ask spreads as wide as 7 to 12 points in a stressed market.

Performance

The fund has indeed done an outstanding job in a rising rates environment, being up on a 1-year lookback:

It is very interesting to note that RISR was for most of 2022 a very good hedge for the long Treasuries iShares 3-7 Year Treasury Bond ETF ( IEI ) which has a similar absolute duration, but on the positive side.

If we look solely at its 2022 performance, the numbers are astounding:

Holdings

The fund currently holds only Agency MBS bonds:

The current portfolio exhibits a negative duration of -7.9 years:

A negative duration indicates the holdings will go up in value as rates rise.

Conclusion

RISR is a fixed income exchange traded fund. The vehicle achieves the rare feat of having a negative duration profile without containing any embedded swaps. The fund holds AAA MBS IO bonds that yield 6.8% currently, and go up in value as rates rise. The vehicle had a stellar 2022, and represents a very nice portfolio duration hedge. For the rest of 2023 we expect the fund to have a stable NAV with its high dividend yield. We are on Hold for this name as of now, liking its duration hedge and dividend yield.

For further details see: