American International Group, Inc. (NYSE:AIG) has a lot of exposure to residential mortgage backed securities. These residential mortgage backed securities are basically a group of mortgages packed into a single document and grouped together based on investment grade. Residential mortgage backed securities are stamped with a risk rating, which is determined by a credit rating agency. The highest rating is AAA and the lowest rating is below investment grade.
The value of these notes can appreciate or depreciate based on market sentiment and the amount of risk investors are willing to take. In this instance, I believe that AIG’s high risk portfolio could have even more upside in an equity bull-market.
AIG’s lending portfolio
The company currently has $16.28 billion in below investment grade mortgage backed securities. This has made investors extremely queasy as high risk mortgage notes could potentially default. However, some savvy investors have earned high rates of returns on these securities as the risk premiums have continued to decline.
As you can see, the risk premium (amount of interest above the risk free rate) has gone down for bonds with a BBB rating. Over the past couple of months, the risk premium has really dropped as ten-year Treasury bond yields have gone up.
Why the risk premium is going down
Ben Bernanke told the joint economic committee he would be willing to raise the federal funds rate once unemployment hits 6.5%. Currently the unemployment rate is 7.5%, meaning we’re not too far from our first round of deflationary monetary policy. It only took a year and a half for unemployment to fall from 8.5% to 7.5%. Unemployment could hit 6.5% in less than two years, which is why investors are dumping bonds onto the open market in favor of stocks. In a deflationary environment, bond interest rates generally go higher.
If interest rates were to go up, the value of bonds that were bought at a lower interest rates go down in value. Rising interest rates have a negative effect on par value (think underlying security value). Investors chase higher risk securities which is reflected in the shrinking risk premium on higher risk debt.
Why AIG invests in junk
American International Group, Inc. (NYSE:AIG) invests into higher risk debt because it attempts to exploit the difference in the perceived risk and actual risk of these investment securities. What this means is that AIG is betting the par value on these securities will rise once bond investors in risk free, low yield treasuries move their cash elsewhere. This sudden increase in demand for high risk bonds will cause yields to fall and par values to go up.