Owning Income Convexity in a Frothy Asset Environment

Our current income portfolios: 

DFMAP (Dividend Focused Multi-Asset Portfolio) 
TAC (Treasuries Across the Curve)
VWI (Volatility Weighted Income)

We were on Yahoo! Finance Morning Brief this Thursday (3/7) discussing the NYCB capital raise and implications for the regional banking sector. Link: https://finance.yahoo.com/video/nycbs-latest-woes-spell-trouble-145119525.html

We were also quoted in GlobeSt.com, a real estate industry publication, on NYCB: https://www.globest.com/2024/03/08/1b-later-and-nycb-still-has-work-to-do/?slreturn=20240209213303

"Indeed, observers are noting that NYCB is just a microcosm of what is happening among many regional banks.

Because property values haven’t repriced for a higher rate environment, this week’s NYCB news means more losses are coming to the regional bank category, Yang Tang, CEO & Co-Founder of Arch Indices, tells GlobeSt.com. “And more struggles are clearly on the way,” he said.

Chat Littell, national director of U.S. capital markets analytics at CoStar Group, agrees that commercial real estate is in for a multi-year price correction."

The situation at NYCB deteriorated in the last month to the point where the Board gave control of the bank to Steven Mnuchin and Joseph Otting. For a 1bn equity investment, they now control a 115bn balance sheet (the majority control comes if they can make it work and exercise their warrants). 

It’s hard to see the upside in owning existing shares of NYCB common stock which trades at 57.5% of tangible book value when Citigroup trades at 67% of tangible book value. This is not an easy exercise ahead and the 7% deposit outflow highlights the challenge. To put into context, we have deposit outflows from bank failures in the past. 

The CRE environment is unlikely to get better anytime in the near future as prices do not reflect cap rates (real estate industry term for net operating income/valuation) in a 5% interest rate environment. We discussed this in depth a month ago: Link.

 

We walked through Grand Central at lunchtime Thursday and saw three Robinhood apps open: all three were checking the price of Nvidia. The equity market is certainly frothy though rich valuation doesn’t mean a crash is imminent. Investors benefit from a risk-adjusted portfolio that participates in the market, not timing the market. 

The continued decline in correlation between 30y government bonds and large-cap stocks provides an opportunity to lower portfolio volatility while participating in the equity market rally.

Chairman Powell reiterated his view that the Fed is not far from the confidence needed to cut rates this week. The rates market is pricing 3.5 cuts this year but income assets become especially attractive if: 

• Risk-assets decline leading to tighter financial conditions
• Real economy slows down and unemployment ticks up

Both scenarios gives the Fed room to cut further and provide price apprecation potential to income instruments.

Not all income instruments make sense for the portfolio. Owning income instruments that have positive price appreciation potential, convexity, benefits investors when interest rates decline. Instruments that generate income from selling options, such as covered calls and mortgage-backed securities, have limited price appreciation potential because the income comes from selling that option. 

 

As always your thoughts and feedback are very much appreciated!