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Bond Yields Fall as Investors Put on the “Risk-Off” Trade

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Basis for long-term interest rates

Ten-year bond yields influence everything from mortgage rates to corporate debt. Now, they’re the benchmark for long-term US interest rates. Some might remember when the 30-year bond was the benchmark, but that changed in the 1990s. When investors want to know what’s going on in the bond market, in essence, they want to know where the ten-year bond is trading.

It’s important to note that short-term rates are still important, particularly the LIBOR (Intercontinental Exchange London Interbank Offered Rate), as it’s the base rate for most short-term rates. Rate information is relevant to REITs like American Capital Agency (AGNC), Annaly Capital Management (NLY), Redwood Trust (RWT), and MFA Financial (MFA).

Investors can trade in the REIT sector through the iShares Mortgage Real Estate Capped ETF (REM) or in the whole financial sector through the S&P SPDR Financial ETF (XLF).

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Bond yields fall on the flight to safety trade

After closing out the prior week at 2.3%, bond yields, as tracked by the iShares 20+ Year Treasury Bond ETF (TLT), fell by 15 basis points for the week ended January 8, 2016. They ended at 2.1%. Bond yields fell as global stock markets sold off on China’s weakness.

The problems in the high yield market have the potential to spill over into the Treasury market as investors move assets to safe havens like Treasury bonds. High yield funds are facing redemptions. They need to sell assets to return funds to investors. The Dodd-Frank Act decimated trading desks and market-making activity. This left the market crowded by sellers with very few buyers. While this has the potential to hit the value of some structured products, most REITs in vanilla MBS (mortgage-backed securities) shouldn’t be affected.

The mortgage REIT sector has been relatively underleveraged since the “taper tantrum” in 2013. The biggest change in the sector has been the move to swap the interest rate risk for credit risk. Mortgage REITs have dry powder—or undrawn capital—if they want to build up their balance sheets again.

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