Market Commentary | January 20, 2025

A funny thing happened during our long wait for lower interest rates. On September 18th, Jerome Powell finally began reducing short-term borrowing costs with a 50-basis point cut to the Fed Funds rate.  At the time, 10y US Treasuries were yielding 3.70%.

In subsequent meetings, two additional cuts were implemented bringing the Fed Funds rate down a full 100bp from the starting point. We don’t always get what we wish for; in this case, it was very painful for fixed-income investors. The 100bp reduction in short-term rates managed to be added to the 10y yield.

Since bond prices and yield have an inverse relationship, this translated to significant losses across a broad duration-spectrum of fixed-income investing. The Vanguard Long-Term Government Bond ETF (VGLT) and Vanguard Intermediate-Term Government Bond ETF (VGIT) illustrate this effect.

Rolling with the Changes

In our early efforts to address first rising interest rates/inflation and now declining rates, we looked to the high-yield opportunities in REIT preferreds. The fixed-to-floating issues offered growing income, no matter how high rates would climb; the steep discounts to par offered attractive capital appreciation potential if interest rates ever declined.

The passage of time and current market conditions present a new opportunity in the realm of fixed-to-floating preferreds. On 01/27/2025, just one week from now, Two Harbors Investments 7.25% Series C Fixed-to-Floating Rate Cumulative Redeemable Preferred (TWO-C) converts to a floating rate coupon. After January 27, the issue will pay a dividend of 501.1 basis points over adjusted 3-month SOFR or 9.56% as measured against a $25 par value.  

We have observed that markets for these thinly traded preferred issues are slow and inefficient, which often creates price dislocations. Those dislocations are now exhibited in the absence of market price declines during rapidly rising interest rates. The issues have been good placeholders in preserving our capital, producing outsized yields, and providing sufficient liquidity to favorably supply capital for the pursuit of opportunities like TWO-C as they emerge.

Ready

Later this year we will see similar fixed-to-floating conversions of issues from AGNC, Chimera, Dynex, and others. No one knows the direction of interest rates, but a thorough understanding of our investment universe, ceaseless vigilance, and constant market presence keeps us ever ready.                            

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