Recommendation: Respect the bond market’s change in trend
The trend has shifted in the bond market
One of the basic rules of trading is to trade the trend. While Market Realist focuses on long-term investing and not trading, that doesn’t mean you should ignore that rule. In early May, Bill Gross of PIMCO tweeted that the 30-year secular (long-term) bond market (which began as Paul Volcker tightened in order to break the back of 1970s inflation) was over. As a long-term investor, you can’t ignore the effects that rising interest rates can have on your investments.
Interested in TOL? Don't miss the next report.
Receive e-mail alerts for new research on TOL
Last week was a perfect example of bear market psychology. The bond market began selling off in earnest on Thursday, presumably on the strong initial jobless claims report. It was a strong report—320,000 initial claims, the lowest in six years. Certainly news that should indicate the economic strength the Fed is projecting us to see towards the second half of the year. But what about the other economic indicators? The Consumer Price Index showed inflation below the Fed’s target of 2%. Industrial Production was flat versus a 0.3% increase. Capacity Utilization fell. Fed diffusion indices like the Empire State Manufacturing Survey and the Philly Fed were weaker than expected. Consumer Confidence fell, while housing starts came in weaker than expected. All in all, it was a mixed bag, and the ten-year bond fell through support and the yield increased 20 basis points. That is bear market psychology—all of the bond-bullish data was ignored, while the market focused like a laser on the piece that was bond bearish.
Implications for mortgage REITs
If you’re a mortgage REIT investor, investing in a bond bear market is a lot harder than investing in a bond bull market. You want to pick your spots, avoiding REITs with high leverage and lots of duration risk. This means avoiding names like American Capital Agency (AGNC), which is highly exposed to the 30-year fixed-rate mortgage and carries high single-digit leverage. There are names that will actually go up in a rising interest rate environment—typically servicers like Nationstar (NSM) and Ocwen (OCN). Probably the biggest mistakes investors make in this environment is focusing on a trailing dividend yield and projecting that forward. When rates increase, REIT profits fall. When profits fall, dividends fall.
Implications for homebuilders
We’re seeing the beginnings of a bifurcated market in the homebuilding sector—where builders exposed to the West Coast and the luxury side of the market outperform, while those at the lower end and that are more geographically diverse underperform. That means names like Toll Brothers (TOL) and Standard Pacific (SPF) are in hotter segments than PulteGroup (PHM) and NVR. We’re seeing the beleaguered first-time homebuyer step away from the market as rising rates crimp affordability.